EU Banks – Re-rating journey finally begins?
As shown in the chart below, EU bank stocks have languished recently near valuation levels last seen at the depths of the global financial crisis, the Eurozone crisis, and even below where we bottomed at during Covid. This is despite the fact that bank fundamentals have turned sharply for the better in the past 24 months, with rate hikes supporting the top line, strong balance sheets and free cash flow generation finally pumping out huge capital return to shareholders. The story, we believe, has been about the market’s lack of willingness to ascribe a higher multiple to what was perceived as “peak earnings”. However, in the aftermath of a solid 4Q earnings season in which EPS upgrades continued to flow through, we are slowly starting to see the market rerate the sector higher from depressed levels – but still have some 30% to go just to get back to the average of the last two decades (which was a fairly dismal decade for the sector).
We see this rerating story as the next phase of European bank outperformance, following the massive earnings upgrade cycle which has driven the stocks over the past two years. If we are right, then the market may well begin to focus on the more lowly-rated bank stocks within what is a very lowly-rated group. And indeed, this is perhaps what we have started to see play out. The below chart shows that stocks with the highest valuations have significantly lagged YTD, while the cheapest stocks are up nearly 25%. In our view, there is much more to go in this rerating and accompanying dispersion within the group.
US Banks – Shifting rates outlook impacting net interest income inflection.
US banks have seen their net interest income (NII) and earnings pressured over the last several quarters as the early benefits of rate increases on floating-rate asset yields have been outweighed by increases in deposit and funding costs. As the market has recently priced in interest rates staying higher for longer – e.g. the forward-curve now pricing in just 1-2 cuts by the end of 2024 vs. 5-6 cuts a few months ago – the hoped-for relief on funding costs has been pushed out. Hence, the bottom for NII for many banks is potentially a bit lower and more elusive than prior forecasts. However, while the NII trough may be slightly delayed, there is reason for optimism that, even in a higher for longer scenario, NII can inflect and move higher for many banks later in 2024 and throughout 2025. Absent rate hikes by the Fed, the meaningful benefit of fixed-rate securities and loans maturing into new higher-yielding, market-rate assets should overwhelm any lingering increases on the funding side which will drive NII expansion and help support a return to earnings growth for the group. In this scenario, bank earnings could grow by 10-15%+ annually in 2025 and 2026 with NII expansion leading the way. Combined with attractive valuations and a potential surge in M&A activity post-election, in time this could well make US banks much more compelling investments than they have been in the past couple of years.
S&P500 – Fear the bear?
The S&P500 experienced its first major pullback of the year, down 5.9% from its peak on March 28th. Statistically, this is the 28th >5% correction off a high since the March 2009 low. They all seemed like the end of world at the time. Yet, in the last 10 years, the S&P500 has returned >200%, of which 55% came from EPS growth, 27% from dividend and 18% from multiple expansion.
Growth matters – A look at history
The US ISM is above 50 for the first time in 17 months, further proof, if we needed any, that stimulus once again has saved the industrial cycle. In June 2023, 27 months after the peak, the ISM bottomed. Over the last 60yrs the average peak to trough is 20 months. Once again, history has been the most reliable indicator. Historically, an ISM above 50 is correlated with cycle acceleration. With mega trends in infrastructure investments and reshoring to follow, we expect a boost in demand. When the ISM is accelerating, EPS growth is accelerating.
Algebris Investments’ Financial Equity and Global Equity Teams
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