By Danilo Masoni

MILAN (Reuters – Expectations for rising interest rates have not lifted valuations of European bank stocks, which are at near 2-decade lows. The worsening economic outlook has weighed on the wider finance sector.

While rising bond yields can be a boon to banks, they also tend to increase interest income. However, the biggest two-month rise in borrowing costs across the euro area since 1994 hasn’t translated into stock market performance for banks.

An indicator of European bank stocks shows a drop of 6% in March. It is still below the previous month’s lows of 14 months. This could be because of fears that recession may follow the Ukraine war.

The historically low positive correlation between bond yields and MSCI Europe Banks has created an enormous gap, which could indicate that the market is poised for a bounce. Refintiv data shows that the correlation between MSCI Europe Banks (MSCI Europe) and German 10-year bond yields has fallen to its lowest point in 90 days.

U.S. banks also saw a similar trend despite the rise in Treasury yields but to a lesser degree.

Graphic: European bank stocks and yields – https://fingfx.thomsonreuters.com/gfx/mkt/klpyklqerpg/Banks%20and%20yields.PNG

This is a hot topic among investors right now and keeps us busy. Jerome Legras is the head of research for Axiom alternative investment in London. “Correlation used to be very strong in the past. The fact that it’s now broken can’t fully explain macro and geopolitical factors.”

Refinitiv data shows that European banks are trading almost 40% less than their average 18-year valuation. This is based on the price to book method. The broader market is 0.3x theirs, which also represents a 40% discount from the average 18-year.

If we are heading toward a recession, this would only justify the current levels. This is what shares are priced at, however, there are no economists or other indicators that are comparable,” he said.

UBS recently made its highest profits in fifteen years. Deutsche Bank Although geopolitical uncertainty and macroeconomic uncertainties have clouded the outlook, (ETR) has extended its longest profitable streak since 2012.

Surging commodity prices and higher rates are a worry. This could cause slower economic activity and reduce deal volumes for banks. Headwinds also grow because of debt repayment difficulties.

Graphic: European banks valuation – https://fingfx.thomsonreuters.com/gfx/mkt/zdpxogaowvx/European%20banks%20valuation.PNG

NOT ENOUGH

Generali (BIT 🙂 Investments has approximately 583 billion euro ($613 trillion) in assets under management and recommends that banks be allocated neutrally, even if valuations seem attractive.

For banks to succeed, they need to support three things: increased yields; moderate credit spreads; and an increase in GDP growth. Michele Morganti (senior strategist, Italian asset manager) stated that rates alone are currently supportive of all three.

According to a London hedge fund trader, a 20% increase in the risk cost would negate the 100-point improvement in interest rates.

Although the ECB will likely raise interest rates by 80 bps before 2022, policymakers remain cautious. Bank of Spain warns of significant indirect effects from Ukraine’s conflict on its economy and banks.

The return to optimism in banks’ past week is evident from the investor positioning on futures markets.

JP Morgan strategists believe that the bond yields will return to normal and that the inflation direction will be aligned with growth again, just as it was prior to the geopolitical surprise. This should result in the return of historical norms for correlations, and filling the gaps which are currently evident.

This may be slow. Generali Investments reports that banks saw one of the most severe twelve-month forward revisions to EPS since Russia invaded Ukraine. Receipt worries were only increased by this week’s decision to reduce gas supplies to Poland and Bulgaria.

Jerome Schupp (a portfolio manager at Prime Partners Geneva) stated, “If I was to build a new portfolio now it would consist of underweight financials… European growth in this year this year will clearly be lower than what is expected due to this war and the price of oil.”

Graphic: European banks earnings forecasts – https://fingfx.thomsonreuters.com/gfx/mkt/jnvwerlxnvw/European%20banks%20earnings%20prospects.PNG