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Equity Perspectives

Shares of leading banks have been hammered lately. Are investor fears overblown? Lord Abbett analysts assess the opportunities and threats in the United States, Europe, and Japan.

Of all the ugly stock charts that have kept investors awake at night this year, none quite compare to the harrowing descent of bank stocks amid a slowdown in global growth and worrisome central bank policies. As of February 18, 2016, banks were the worst performing sector in Japan and Europe, down 30% and 22%, respectively, and the second worst in the United States, down 27%, according to Bloomberg. 

Clearly, the market has been concerned about some banks’ ability to earn a competitive return. But some market observers believe recent underperformance has created value opportunities. In Europe, for example, banks have been trading at valuations close to the summer of 2012, when European Central Bank president Mario Draghi vowed to do whatever it takes to boost the economy. In Japan, with 10-year government bond yields at zero, the three largest banks, as of February 18, were selling at approximately half their book value,1 which is the lowest they’ve been during the last 15 years, according to Bloomberg.

Stormy Europe
When four of Europe’s largest banks experienced a massive sell-off last week, Lord Abbett investment professionals were quick to put the rout into perspective and allay client fears that those institutions’ troubles might signal another financial crisis. 

Harold Sharon, Lord Abbett Partner, International Strategist, International Equity, with the benefit of his 33 years in the financial industry, was able to tick off the forces that precipitated what some observers called a “financial hurricane” in the European banking sector.  

Among the more notable factors was the nasty combination of negative interest rates (whereby depositors are actually charged to keep their money in an account) and huge liquidity requirements, which in turn hurt earnings.

Adding to the malaise was the Bank of Portugal’s move that makes private bondholders’ investments in one Portuguese bank's senior debt nearly worthless. Fears of similar “bail-in” scenarios for troubled banks in Italy also rattled markets. Then there was the potential for mining and energy debt to start showing up on banks’ balance sheets as nonperforming loans (NPLs), particularly in Italy, where NPLs have been high for some time. 

“In addition to all that,” Sharon said, “regulators, more than seven years after the financial crisis [2008–09], have been way too slow to really clarify exact rules on things like capital requirements for credit, market, and operational risk [which determines their ability to lend, expand, contract, and reward shareholders and employees], the definition of risk-weighted assets,2 and so forth.”

Europe Needs to Delever More
While the trends in European banks have been similar to those exhibited by U.S. banks, Yoana Koleva, a Lord Abbett fixed-income research analyst, said the pace in Europe has lagged on several fronts, citing:

  • The nominal leverage of the European banks remains higher than that of the United States, and there is need for further deleveraging.

  • There is still more work to be done in restructuring the capital markets operations of the big European investment banks, where profitability, near term, is very depressed.

  • The European banks have more legal charges to recognize, unlike U.S. banks, which are much farther along with that painful exercise.

Hot CoCo Issues
Koleva also expressed concern about the pro-cyclicality created by the structure of so-called contingent convertible (“CoCo”) bonds3 and other Additional Tier 14 securities with high yields, which have been used by banks to shore up their balance sheets. If regulators mandate stricter capital levels, investors counting on those coupon payments could be left in the lurch.

“These are very complex instruments, difficult to value, and the European regulators have left unanswered questions as to how exactly the coupon treatment of these instruments works,” she said. “The negative feedback loop that has been created between these instruments and equity is worrisome in what is a highly confidence-sensitive sector and might impair banks’ abilities to react to unforeseen adverse developments.”

While some investors worry about the economic impact on the eurozone if banks were to accelerate their deleveraging, Koleva said the current situation is very different than 2008/2009 and 2011 periods. Unlike that time frame, liquidity now is plentiful. There is no liquidity crunch, and evidence of that is the senior bond tender that one major European bank recently announced.

Some European banks might see some credit deterioration, primarily within their energy portfolios, but considering that these banks have been delevering over the past six years, Koleva found it difficult to envision credit problems becoming so severe as to lead to significant capital destruction. “Usually the most severe credit losses come out of periods of significant growth, not shrinkage,” she added. “If there are any solvency concerns with the sector, I think they are misplaced.”

U.S. Banks
When Greg Wachsman, a Lord Abbett equity research analyst, presented his semiannual outlook for the banking sector in early January, he certainly wasn’t expecting a banner year. Among universal banks and bulge-bracket brokers, he favored one particular institution and suggested avoiding the rest of the group.

With regional banks sporting rich valuations relative to fundamentals, Wachsman favored super-regional banks, assuming valuations could increase and that certain banks could monetize excess capital through mergers and acquisitions. However, with emerging credit issues, particularly in the energy, auto, and commercial real estate industries, he suggested portfolio managers and colleagues consider names with valuations and earnings estimates that fully reflected those risks.

By February 9, universal banks and bulge-bracket brokers were the worst hit of Wachsman’s sectors, with total return down 18% on a year-to-date basis. Many of the same factors affecting regional banks had also hurt the big banks, and adding to their woes were the “tail event” risk of counterparty concerns, given the weakness in European bank earnings reports and wider bond spreads.

“Capital markets revenues will also be tougher before they get better, with the first quarter of 2016 presenting a challenging year-over-year comparison,” said Wachsman. “The [large banks] group started the year as fairly valued, in my view, and the sell-off has made them modestly more attractive, but the reward/risk is overall not compelling versus other subsectors.”

Commenting on both regional banks and money center banks and brokers, Wachsman noted that because earnings per share were coming down from lower interest rates, valuations should move lower as growth prospects moderate. Large-cap banks, for example, are trading about 20% above their 2011 price-to-tangible book lows, according to Bloomberg, and Wachsman thinks downside risk exists should the U.S. economy slip into recession. 

While super-regional banks were the best performing subsector, albeit with a total year-to-date return of -12% as of February 9, according to Bloomberg, such stocks are not immune to lowered rate expectations or credit-quality concerns. But some analysts have maintained their positive outlook on the group, given their modestly improved risk/reward profile. Underlying that thesis is the notion that this subsector should represent a defensive play relative to other levered, rate-sensitive financials, given high capital, liquidity, and more diversified business models.  

As for the fixed-income outlook, Koleva remained constructive on U.S. banks. After all, the balance sheets are strong, capital levels are high, regulation is significantly more stringent, and banks undergo a robust annual stress test that allows the regulators to control capital return to shareholders.

“While we saw what an inflection point in credit costs this quarter, it’s worth noting that credit losses are at an all-time low, and significantly below normalized levels, and I view any increase and return to normalization as an earnings concern and not a credit concern,” she said. “Furthermore, being highly regulated entities, the banks are less likely to be involved in the leveraging activities that we’ve seen with other sectors.”  

 

1 Book value is generally defined as a company's common stock equity as it appears on a balance sheet, equal to total assets minus liabilities, preferred stock, and intangible assets such as goodwill. This is how much the company would have left over in assets if it went out of business immediately.
2 Risk-weighted assets (RWA) are generally defined as a bank's assets or off-balance-sheet exposures, weighted according to risk. This sort of asset calculation is used in determining the capital requirement for a financial institution.
3 Contingent convertible capital instruments (CoCos) are hybrid capital securities that absorb losses when the capital of the issuing bank falls below a certain level.  The spreads of CoCos over other subordinated debt greatly depend on their two main design characteristics - the trigger level and the loss absorption mechanism. CoCo spreads are more correlated with the spreads of other subordinated debt than with CDS spreads and equity prices.
4 Additional Tier 1 (AT1) capital generally refers to a bank’s “going concern capital.” Under the Basel III Framework, to qualify as AT 1 capital, an instrument must: be issued and paid-in; be subordinate to depositors, general creditors and subordinated debt of the bank; and be neither secured nor covered by a guarantee of the issuer or a related entity, among other requirements.

 

Investing involves risk, including the possible loss of principal. The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future. No investing strategy can overcome all market volatility or guarantee future results.

References to specific securities and issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities. The data contained herein is being provided for informational purposes only and is intended to illustrate certain information analyzed during the research process. It does not constitute a recommendation or investment advice, and should not be used as the basis for any investment decision. This is not a representation of any securities Lord Abbett purchased or would have purchased or that an investment in any securities of such issuers would be profitable.

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