Ahead of the Curve | Friday, 26th March 2021

Investment banking remains on fire – Very strong start to 2021.
Amidst all the attention on rising rates in the past few weeks, another important driver for bank profitability has slipped under the radar. Capital markets activity, which drives investment banking revenues, remains on fire in 2021 after a very strong performance in 2020. At a recent conference, Credit Suisse commented that investment banking revenues in 2021 thus far are up 50% year-over-year. This is perhaps unsurprising given Credit Suisse’s leadership in SPACs, which are seeing unprecedented growth. However, Deutsche Bank also commented that investment banking revenues are up 20% year-over-year. Barclays didn’t provide specific figures, but talked about the ‘Roaring Twenties’ when describing current market activity. In the US, Jefferies reported results for their fiscal quarter ending February 28, 2021, with investment banking revenues up a staggering 71% year-over-year.

US yields have become historically attractive to foreign investors – And are likely to push up global yields from here.
The size and depth of the US Treasury market make it an anchor for global interest rates, and the recent rise in US Treasury yields has made them particularly attractive for foreign investors for the first time in years. For example, today 10y US Treasuries provide a spread of 125bps over 10y German Bunds on an FX-hedged basis. Since the formation of the Euro, this spread has averaged 16bps and has rarely been higher. This suggests that a further rise in US Treasury yields is likely to pull rates higher in Europe, even if the European recovery does not take place at the same velocity as in the US. We see the same phenomenon in the UK, with the FX-hedged spread over 10y Gilts at 129bps, vs an average of 33bps over the same period. In Japan as well the FX-hedged spread over 10y JGBs has ticked up to 78bps – the highest level in the post-GFC period. This is perhaps less surprising given the Bank of Japan’s Yield Curve Control policy, where it targets the level of 10y JGBs to 0bps. However, this phenomenon also likely contributed to the BOJ’s recent decision to allow 10y JGB yields to rise up to a level of 25bps.

Market still not paying up for European banks that have track record of generating value for shareholders.
As bank investors we are deeply focused on the ability of bank management teams to create value for shareholders in two ways: generating solid compound growth in tangible book value per share over the medium/long term, while at the same time returning free cash via dividends. In fact, there is a strong correlation between these two value drivers and the P/TBV multiple of a given stock, with an R-squared of nearly 80%. Essentially, the market is rewarding those banks that can grow book value and still pay out healthy dividend streams. Unsurprisingly, American and Nordic banks have created significant value for their shareholders and their stocks reflect as much with rather rich valuations. What we find interesting, though, is several of our key holdings in Europe appear to trade at significant discounts relative to what their value creation over the last five years would imply. Stocks like SocGen, Allied Irish, ABN Amro, and even Commerzbank, all have 50-75% upside from their current P/TBV valuations (which for the three range between 0.25 to 0.50x) based on this analysis. Yet another lens through which to view the deep discounts currently on offer in European banks.

Another week, another M&A bid – Chubb bids for Hartford.
We saw another large takeover bid announced in our space this month, with Chubb looking to buy Hartford (HIG) in a ~$23 bn deal. While HIG rejected the offer, we expect there is more to this story as Chubb likely will raise their offer in the near term. The initial $65 bid was clearly too low and we believe Hartford is unlikely to entertain any offer sub $80. The company has several valuable ancillary businesses, each of which could be sold off to the highest bidder; between its group benefits, asset management, and personal lines units, any buyer of HIG could like recoup ~$12 bn of the initial purchase price. Assuming a $80 bid, that would suggest the buyer would be paying just ~10x for HIG’s crown jewel, their small commercial insurance business. This seems altogether too low. With potential other interested bidders (Berkshire, possibly Travelers or Allianz), there could be an auction here and if HIG refuses to negotiate their management will be under heavy pressure from activists. All in, the risk reward for HIG looks good with the stock in the $60s, and we suspect there could be secondary impacts too as other insurers are forced to chase scale – a new wave of M&A could beckon.