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ECB rate hikes will boost European bank stocks in 2019

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ECB rate hikes will boost European bank stocks in 2019

European bank stocks took a battering in 2018, but 2019 may turn out to be better if the ECB raises interest rates, according to analysts and investment specialists.

Investors have used liquid bank stocks to play interest rates and went into 2018 expecting European reflation and near-term rate rises, according to Pierre-Henri Flamand, chief investment officer of fund manager Man GLG, and the fund's portfolio manager Giovanni Baulino.

"However, a mixture of negative economic data surprises and [ECB President Mario] Draghi's dovishness has sent the market in the opposite direction," they said in a Sept. 20, 2018, market note.

The STOXX Europe 600 Banks index fell to 132 points as of Dec. 31, 2018, from 184 points on Jan. 2, 2018, while the main STOXX Europe index fell to 338 from 388 over the same period.

Higher rates, if applied sooner, will drive net interest margins and bank earnings, UBS equity analysts said in their 2019 outlook for global banks.

"[S]hould bank investors begin to believe in higher ECB rates [...] we see upside to valuation multiples and longer-term EPS estimates," they said Dec. 9.

The ECB, which held rates low as a post-crisis measure to stimulate the economy, is gradually moving toward normalizing monetary policy. The central bank announced Dec. 13 that by year-end it will complete its quantitative easing program, launched March 2015. The first rate hikes are expected to follow in the third or fourth quarter of 2019, according to UBS.

'Key worry'

"The key worry for European banks is that Europe misses the chance to hike rates ahead of the next downturn," UBS warned. Both valuations and profitability would be hit if rates stay low for longer, the analysts said.

If rates increase, the outlook for European banks' market pricing in 2019 is positive, even with risks such as the U.K.'s exit from the EU, exposure to volatile markets such as Italy and Turkey, and potential litigation issues in light of recent money laundering scandals at some large domestic institutions, according to UBS.

"[I]f one believes Draghi when he says he will be raising rates a year from now, then it's our view that — for the best-run banks, at least — you'd need some fairly apocalyptic tail events to justify current pricing," Flamand and Baulino said.

European banks are currently earning returns on equity of about 6% to 7%, with cost of equity above 10%, according to Man GLG estimates. UBS sees 2018 ROE at 8.9% for European banks and projects an increase to 9.2% in 2019. UBS puts its current cost of equity estimate at 10.1%.

Both Man GLG's investment specialists and the UBS analysts believe strong capitalization is an advantage for European banks, making them more resilient to future shocks.

"We see good risk-reward in a number of well-capitalized, capital-generative banks caught in the sector sell-off year-to-date," UBS analysts said.

Generally, 2019 should be better for European banks than 2018 given an expected pickup in the global economy as well as relatively stable net interest margins and asset quality, according to UBS.

Man GLG's managers are even more positive, saying that even if rates do not rise, or rise at a slower pace than expected, and geopolitical risks remain high, there are still "well-run banks whose pricing offers investors something close to a free option on all of these potential outcomes, whilst compensating them with an impressive running dividend yield — averaging around 6% — in the meantime."