Olly Russ

The return of confidence in Europe

Olly Russ

This weekend we saw the Italian government bail out two failing banks (Veneto Banca and Banca Popolare di Vicenza) in an arrangement which could cost the taxpayer €17bn, while handing off the ‘good assets’ to Intesa Sanpaolo. This follows the effective failure of Spain’s Banco Popular Espanol, which was acquired by Banco Santander for the symbolic sum of 1. These events have barely caused a ripple in the markets and the UK papers’ minimal coverage stands in stark contrast to the headlines generated by the European periphery this time last year. There has also been a sea-change in investor behaviour; whereas last year they were reacting impulsively to fears both real and imagined, now they are fairly sanguine about these latest signs of stress in the European banking system.

So what has changed? In short, confidence has returned to the European economy, and by extension, the European banking system and equity markets.

European Consumer Confidence

Olly Russ: The return of confidence in Europe - European Consumer Confidence

Source: European Commission, Bloomberg.

Early last year, investors were being routinely bombarded with the phrase ‘lower for longer’, in reference to the outlook for interest rates. In the immediate aftermath of the UK’s Brexit vote, it was felt that ‘zero forever’ was rapidly becoming market consensus. In the febrile atmosphere of last summer, the eurozone banking system was believed once more to be sinking beneath the market’s waves: the Italian banking system was purportedly about to fail as some of the second-line banks experienced capital difficulties, while the EU (with its customary alacrity in a crisis) hesitated over whether a rescue by the Italian state was technically permissible. Nor were problems confined to the periphery: Deutsche Bank was also apparently facing obliteration as a result of US legal liabilities. The usual mongers of Doom were pointing to the size of Deutsche’s balance sheet and derivative exposures, and the obvious impossibility of printing enough money to fill such a black hole. By early July, the European bank index had halved inside a year. Again.

No sooner was consensus reached, than markets began to reverse in the other direction. Far from going bust, Deutsche Bank was to double from its lows within four months. The Italian banking crisis never quite materialised. Project Fear ahead of Brexit turned out to be Project Only Very Slightly Disconcerted in actuality. By the end of the year, the apparently unthinkable had happened again, and Donald Trump was heading for the White House. Yet by early May 2017, the European banks index had risen c.65% since last summer. An existential crisis had apparently been averted once more. Even the most resolute optimist would not claim that all of the European banks’ problems were over however.

Yet here we stand, with shares in Intesa Sanpaolo and Banco Santander displaying little concern that they have been cajoled into absorbing assets from failed banks. Indeed, Intesa today (which we own as the best capitalised major Italian bank) is up almost 5% on the news. In Spain, if the sticker price for Banco Popular (€1) looked good value, it should be borne in mind that Santander itself was required to launch a €7 billion rights issue to support its new acquisition. Nonetheless, a chart of Santander’s share price shows barely a ripple on the news, which might be thought courageous by any shareholder in Lloyds Bank who remembers the HBOS acquisition. 

Intesa Sanpaolo, share price
Banco Santander, share price 
 Olly Russ: The return of confidence in Europe - Intesa Sanpaolo, share price  Olly Russ: The return of confidence in Europe - Banco Santander, share price

Source: Bloomberg.

In many ways, the Santander transaction was a victory for the EU’s new Bank Resolution Scheme. Popular had failed its capital test in 2016, and had yet to find a way to remedy the situation. As a run on deposits began to undermine the capital position further, the ECB determined that in accordance with Article 18 (1) of the Single Resolution Mechanism, Popular was failing or likely to fail. It might be said that the ECB were lucky in that Santander were ready to catch the falling bank, a considerable statement of confidence in Santander’s own capital position. Of perhaps more significance was the wider market impact, which was very much the dog that didn’t bark.

Whilst a few individual banks may still suffer from existential crises, the systemic crisis in the eurozone banking system is now over, and individual bank failures can be effectively insulated from the system as a whole. This might be of small comfort to the shareholders of Popular (who subscribed to a EUR 2.5 billion rights issue just last year), and not indeed to the owners of the contingent capital bonds, which were also wiped out, but that such a significant failure could occur in a controlled manner shows just how more robust the system is than five years ago. Immediately post-Brexit, the eurozone banking system traded on more or less the same price to book valuation as during the depths of the crisis. But six years ago or so, it was supposedly the Baltic exposures of the Nordic banks which were set to collapse the whole financial architecture of Europe. That didn’t happen either, and the Scandinavian banks are now in general heavily over-capitalised, with names like Swedbank generating hefty c.6.5% yields. The overall capital situation of 2017 bears no resemblance to 2010, and neither should valuations.

MSCI Europe Banks Index – Price to Book

Olly Russ: The return of confidence in Europe - MSCI Europe Banks Index – Price to Book

Source: Bloomberg.

Banks ultimately depend upon growth, which has been in somewhat short supply in recent years in Europe. However, there are now more and more encouraging signs as the European economy normalises, and even previous laggards begin to fire on more cylinders. By way of illustration, one can see the movement in European earnings forecast this year. Whereas for each of the previous six years or so Europe has seen nothing but relentless downgrades, 2017 is marking the most significant turn in almost a decade, as a properly functioning eurozone economy begins to power domestic earnings (combined with a rest of the world also doing quite well).

This earnings growth – if sustained – should represent the beginnings of a virtuous circle of declining bad debts leading to more capital being available for loans, leading to more growth, and so on. There are also encouraging signs that overseas investors, long fearful of Europe due to its frightening potential political complications, are also returning, which could be a welcome boost to markets. After all, it is the political events not in the calendar that normally turn out the most eventful – just ask the UK.

Europe ex-UK – consensus EPS progression
Olly Russ: The return of confidence in Europe - Europe ex-UK – consensus EPS progression

Source: Bloomberg, I/B/E/S.


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Tuesday, June 27, 2017, 1:42 PM