European Banking Stocks’ Onerous Outlook: Five Things to Watch

(Bloomberg) --

The economic fallout from the coronavirus has battered a sector that never recovered from the global financial crisis more than a decade ago. The focus for the rest of the year is on how banks can handle looming loan losses, whether any will be able to pay dividends, and possible further regulatory relief.

Europe’s Stoxx 600 Banks Index is down 34% this year, the worst-performing industry group in the period, with many investors remaining underweight on lenders even as economies start to reopen.

“The long-term fundamentals appear unattractive,” JPMorgan Chase & Co. analysts including Kian Abouhossein wrote in a note this week. “Most investors believe European banks won’t earn their cost of capital in the medium-term,” according to a survey of more than 60 institutional money managers.

On the positive side, the sector’s valuation isn’t demanding, and capital positions remain strong for most lenders, while the European Central Bank is willing to offer cheap refinancing and other measures to ease the burden of negative rates. The combined target price for the Stoxx 600 Bank Index on a 12-month basis implies about 15% upside.

With second-quarter earnings season about a month away, here are five things to watch for the remainder of 2020:

Loan Losses

Souring loans are the biggest topic in the coming quarters as provisions are expected to have the greatest impact on profitability. The picture in the first three months of the year was mixed as banks took different views on how much to put aside for bad debts. The common ground is that a huge chunk of loan losses still lies ahead.

“Banks will be in a better position to assess the impact of the coronavirus pandemic on asset quality in their second-quarter results, now that the effects of lockdown measures and monetary and fiscal policy responses are becoming clearer,” analysts at Fitch Ratings said in a statement this month.

Creditreform, a German credit agency, sees a “wave of bankruptcies of unseen dimension” in Germany later this year and analysts at Barclays Plc cut their ratings for BNP Paribas SA and Societe Generale SA to underweight because they estimate more impairments from consumer credit in France.

Dividends

With most dividends either fully suspended or postponed in the wake of the coronavirus, expectations for such returns this year have slumped, according to the survey by JPMorgan. Regulators have increased pressure on banks to build capital for potential losses and the political consensus seems to be that state aid for the economy can’t go hand in hand with payouts to investors.

The ECB’s Single Supervisory Mechanism has said it will provide clarity on its dividend ban in July which could offer more visibility on which banks will be able to make payments, Bank of America Corp. analysts have said.

“A predictable capital framework is essential for equity investors, BofA said. “The framework was thrown into disarray by the dividend ban. Capital ratios are of almost no value if there is no figure above which a bank is able to make payments to its owners.”

Yields, Tiering and Capital

The coronavirus crisis has cemented the low yield environment in Europe. Massive government aid programs and high levels of state debt and can only be sustained if borrowing costs remain low, making it hard to see a near-term turnaround.

Such an environment typically hurts profitability on mortgages and other loans, though banks are adapting to this landscape by passing through some of the impact of negative rates to clients.

The European central bank has also introduced a so-called tiering system allowing banks to avoid some of the negative yields on excess liquidity and is offering ultra cheap funding to encourage lending to the economy. European lawmakers are set to provide capital relief for banks holding sovereign debt and more regulatory relief could be on the agenda later this year.

Flow Show

Investment banking has had a little renaissance in the first half of the year as high market volatility boosted securities trading revenue. The guidance from executives suggests that some of this momentum continued in the second quarter. UBS Group AG -- which is seen as having 14% upside by analysts tracked by Bloomberg -- may provide further evidence as the first major bank to report results for the period on July 21.

Still, not all banks have benefited. French lenders saw revenue from equities trading wiped out in the first quarter by heavy losses on complex derivatives. And Societe Generale already signaled it may have missed out on the trading boom that buoyed rivals in the second quarter.

With markets on a bumpy path there’s a higher chance of some trading surprise or one-time losses that might skew quarterly reports to the upside or downside.

Less Weight

Banks’ overall weighting in major European benchmarks is at an historic low as their market capitalizations have shrunk. In recent years, lenders like Deutsche Bank AG and Commerzbank AG have dropped out of major equity gauges such as the Euro Stoxx 50 and DAX Index. This month, Societe Generale came close to being replaced by technology investor Prosus NV in the Euro Stoxx 50.

The French bank, which has fallen 54% this year, is seen as having a return potential of about 21%, according to analysts tracked by Bloomberg.

But falling out of such benchmarks means less money is allocated from passive investors into the sector. The picture isn’t much different among active portfolio managers as the JPMorgan survey showed that 42% are underweight on the banking industry group versus 32% being overweight.

©2020 Bloomberg L.P.