Though banks’ share prices have not been immune to the relentless selling pressure we have been seeing in the markets, it is worth noting that this time around they are not the core of the problem. Instead they are increasingly viewed as part of the solution. Rather than having to recapitalise banks, governments are providing guarantees to stop loans defaulting in the first place (both retail and commercial support, in effect shielding bank shareholders from loan losses) and so potentially enabling the banking sector to provide finance in the face of illiquidity in broader capital markets. This is almost the opposite of what happened during the global financial crisis (GFC) and could see the start of loan growth. In all the current turmoil it is worth noting the following:
- Evidence of strong deposit inflows into US banks (+7.8% q/q annualized in 1Q20) so they have ample liquidity (aided also by central banks globally opening the QE taps) with US bank loans/deposit ratios 80% (versus 100% in 2008) and 99% at European Banks (versus 149% in 2008).
- Capital levels remain well above GFC levels providing greater ability to weather a loan book downturn and some capital requirements being relaxed. US bank equity/assets 10.4% in 2019 versus 6.8% in 2008.
- Capital levels have also faced regular stress tests with US banks tested for a 9.4% fall in GDP, a 26% fall in residential real estate prices and a 6.2% rise in unemployment.
- Significant regulatory forbearance regarding non-performing loans, new accounting standards and the relaxation of capital requirements (such as the recent ECB measures that will reduce core Tier 1 requirements by €120bn).
We have shifted some of the portfolio to more diversified loan books of major banks in the US, which are also likely to be helped by strong trading revenues on the back of high volatility. We also expect deterioration in loan books but low interest rates and government support mechanisms are likely to provide a break on the extent of losses.
- Margins will compress further, but some banks sectors have already been functioning with negative rates for many years and earned reasonable returns.
- Valuations are already pricing in worse than GFC loan-book deterioration in Europe and the US. The MSCI World Bank Index has never been cheaper on a relative P/B and only cheaper for two weeks in 2009 on an absolute P/B.
- Buying the sector at this multiple has historically resulted in strong three-year returns.
- Buybacks have been cancelled in the US and pressure on European bank dividends alongside low valuations means, even after dividend cuts, there is likely to be ample income generation from the sector to meet our 3% dividend income yield promise.
- Stopping buybacks will, however, enable banks to provide funding and we suspect governments will provide enticements to get banks to lend (i.e. limits on downside).
- We are seeing a dramatic structural shift to digital banking, eventually enabling a complete reassessment of branch networks.
Finally, it is worth noting that the sector was already attractively priced prior to the current selloff and today is offering one of the best opportunities to invest – for example, Citigroup is trading at 0.4x book and with a 6% dividend yield – even as there is growing evidence that this time around they are not the problem.