Financials? Tactically long

Credit Suisse remains tactically overweight of financials with a focus on retail banking and GEM exposure. What is supportive?

Bear market rallies can last for longer: European banks have performed in line with their average bear market rally (13% outperformance over two months) but some bear market rallies in Europe saw 25% outperformance (as did 7 out of the past 15 rallies seen in Japan).

Macro drivers: The key macro drivers are bond yields and PMI. Using these inputs, our simple model suggests 9% upside potential to European banks relative to the market. We think that the risk is bond yields head higher than clients believe (as governments ease fiscal policy and move away from NIRP, US wages grow, headline inflation accelerates, and the BoJ and ECB start to run out of bonds to buy in 2018).

Valuation: For the first time since 1999, European banks are cheap on both dividend yield and PE relative to the market. The 2018 dividend yield is the highest in the market (6.2%). If we assume our banks team’s forecast of an 8% RoE in 2016 and €100bn of capital raising/unfunded litigation, then we think European banks should trade on a P/TB of 0.86x, or 15% higher. P/TB relative to US banks remains extremely depressed.

Profit drivers: Danish and Swedish banks have the highest ROE in the developed world despite operating in the most negative and prolonged NIRP environment. To us, this shows that concentrated banking systems have proved relatively successful at passing on the impact via fees and deposit rate reductions (and some European countries still have high household deposit rates). Credit spreads/default rates imply lower provisioning, with the key being that mortgage rates are so far below rental yields that collateral values should continue to improve. Our proxies on loan growth (M1 and demand for credit) suggest an acceleration. Cost cutting potential, aided by fintech, could be significant (Swedish banks have 16% of branches p.c. of the periphery); the most efficient banks have cost to income ratios of c.45% compared to a European average of 61%. Other factors: earnings and dividend downgrades are stabilising.

What to buy: From a European perspective, we like banks offering an attractive PTB/ROE trade-off (French banks – Natixis and Credit Agricole); above all retail banks (less disintermediated, more exposure to improving real estate trends, more cost cutting potential – ISP, Bankia, Erste and Nordea); and DM banks with GEM exposure (still look c30% cheap on sum of parts).
Globally, we like Japanese banks, but find some factors less supportive for the US banks in a global context (provisioning, valuation, signals of slower loan growth). We stick to our overweight of UK life companies (upgraded in July).
They look abnormally cheap versus fund managers with less regulatory, litigation and taxation risk than the banks. Long term, we are more cautious of financials given regulation and fintech risks.

Equity Research – Credit Suisse