Banking sector: a stock market opportunity for 2024?
María Torres de Becerril, equity portfolio manager at MAPFRE AM
Over the last decade, there has been a substantial improvement in the solvency and liquidity of the European banking sector, thanks to regulatory reforms and the efforts of companies to improve risk management, operational efficiency and organic capital. However, the ability to generate revenues, which had become complicated in the wake of the 2008 global financial crisis, was hampered by the low interest rate environment.
It was at the last meeting in July 2022 that the European Central Bank (ECB) implemented the first interest rate hike and since then, rates have risen by 450 basis points (bps) in just one year, principally aimed at combatting high inflation. It is foreseeable that interest rates have peaked and that they will remain at higher levels for longer than expected. However, the market is starting to discount the first rate reductions for the second half of 2024.
The interest rate margin will continue expanding in 2024
The positive impact of interest rate hikes is expected to continue for a large part of 2024, given that they take a while to be replicated in the cost of credit. On the liability side, there is not a lot of pressure to pay for deposits and we believe that, in Europe, the deposit beta will gradually increase to approximately 35-40% levels, on average, for 2024-20255 (in July 2023, it stood at 20%, on average). From the end consumer's point of view, a preference is being seen for the early amortization of credit rather than a demand for higher remuneration for deposits.
Another important aspect for 2024 that will positively affect the interest rate margin, especially for French and Benelux banks, is the renewal of hedging derivatives that have been used during the past few years to hedge their fixed-rate assets against interest rate hikes. On average, it is estimated that European banks have coverage representing approximately 57% of their deposit base with a profitability of about 1.4%, which is expected to increase to 2% in 2025.
On the negative side, low credit growth or increased wholesale financing costs will put pressure on the interest margin. However, if the Euribor remains more or less at 4% levels, these negative impacts are expected to be offset as the loan book and coverage management are renewed.
Record shareholder remuneration
The sector enjoys capital levels comfortably above capital requirements. On average in Europe, an excess of 400 bps of capital is estimated for 2023-25, equivalent to 35% of the market capitalization of European banks. From a regulatory point of view, the last reform package established in 2018 must come into force next year, but the impact has already been taken into account as far the sector's capital plans go. As such, in 2024, banks are expected to continue with attractive shareholder remuneration, with regular dividend yields of 8%, which would be 12% if share buybacks are factored in.
Heightened uncertainty and risks
The banking sector is not without risks. On one side there are political risks, translated into new taxes on banks or the temporary extension of same in some countries where they have already been implemented, as is the case with Spain. While it is true that these impacts will be mitigated in large part by the finalization of contributions to the Single Resolution Fund (SRF) and extraordinary contributions to Deposit Guarantee Schemes (DGS) in 2024.
Also to be considered are the risks associated with the volatility of debt markets and the upturns in sovereign spreads. Italy's publication a couple of weeks ago of a budget deficit in excess of what was expected widened the performance differential between Italian and German debt. Although the spread didn’t reach alarming levels, it has highlighted the risk of fiscal deficits and the need to reduce them, particularly in the case of peripheral countries. These risks translate into latent losses in the bond portfolios of financial institutions recorded at fair value with changes in equity, which reduce the capital ratios of financial institutions.
Likewise, debates associated with the withdrawal of the sovereign and private debt buybacks program approved during the pandemic, or the increase in the minimum unpaid volume of mandatory reserves, will continue to be a source of concern for investors.
The most significant tail risk in the sector is a significant macroeconomic deterioration that leads us to a recessionary situation, as opposed to a slowdown, and a downward trend in rate expectations and, therefore, the Euribor. This scenario would have a negative impact on credit volumes, interest margin revenue and asset quality. In the latter point, it should be noted that the sector has surplus provisions, thanks to the improvements made in regulations (IFRS 9) and adequate risk management.
Very attractive valuations, but stock picking must be at the fore
The sector is currently trading at 0.7x P/NAV, giving us a RoTE of more than 11% for 2024. Historically, the cost of capital in the banking sector has fluctuated between 8% and 11%, being in the low band at times of economic bonanza and in the high band during a slowdown and/or periods of increased risk. At current levels, the sector is trading at an implicit cost of capital cost of around 14%, which is excessive considering the current balance sheet strength and profitability and earnings expectations for 2024-2025. We should see a recovery in stock prices of the sector's players, but the market risks for 2024 are high and difficult to quantify, so it isn’t easy for them to maximize their full potential. In this scenario, it’s very important to be highly selective.
Since the end of 2022, the market focus has been on eurozone banks with interest rate leverage and excess capital that have a shareholder distribution commitment. Looking ahead to 2024 and taking into account the risks facing the sector and that growth in Europe will slow down, perhaps the focus will be more on diversified global banks with exposure to LATAM countries. Close attention must also be paid to banks implementing changes in their fund management teams and which are currently trading at an excessive discount against the sector itself. This could result in an improvement in their share price if the objectives of the banks’ strategic plans are achieved, as well as for those institutions committed to above-average shareholder remuneration, which are trading at a discount against their profitability/risk profile.