Summary
- Despite outperforming US banks by 2.5x over the last three months, European financials trade at a significant discount on a P/BV basis.
- The rate environment bodes well for the NII trajectory but risks related to the asset book should not be dismissed.
- In the short term, EUFN looks overbought.
Overall, European banks are entering this current phase having demonstrated resiliency throughout the pandemic.” - DBRS Morningstar
Introduction
If you're a member of The Lead-Lag Report subscription service, you'd note that in this week's "Leaders-Laggards" section of the report, I've highlighted how a ratio measuring the strength of a portfolio of developed market securities (ex-US and Canada) over the S&P 500, has recently hit its highest point in 16 months. What’s interesting is that most of these stocks are based in the European region, a region whose prospects I had drummed up over a month ago. Meanwhile, institutional interest in European equities has shifted from a 10% underweight position in December to 4% overweight in January.
The product I'll be reviewing today comes from this hot terrain and also has enjoyed a fine run relative to its US counterparts. I’m referring to the iShares MSCI European Financials ETF ( EUFN ) which offers coverage to 77 European equities exposed to the financial sector. Over the last three months, EUFN has been on fire, and has outperformed its US counterpart- XLF by 2.5x. In addition to that, despite the bout of outperformance, on a price-to-book value basis, EUFN still trades at a ~65% discount to XLF .
Should you forge ahead with EUFN? Well, here’s what I think.
Important themes
For these financials to flourish, you’re going to need the macro backdrop to be steady enough, and while nobody is expecting a stellar outlook in Europe, it must be said that things have held up reasonably well so far. Initially, it looked as though the energy crisis would wreak havoc in Europe and push the region into a deep recession, but the narrative has changed quite dramatically, primarily on account of a mild winter.
A few weeks back, I had highlighted how Dutch front-month gas futures had slumped towards the end of the year from levels of EUR350 in August. That trend has persisted, with the price now falling to its lowest point in 16 months.
This has understandably boosted economic sentiment, none more so than in Europe’s largest economy - Germany. Last month I noted how the reading at come in at its highest point in 10 months, you’d be interested to know that the sequential improvement has continued in Jan and crucially the gauge jumped into positive territory for the first time since February 2022.
The re-opening of the Chinese economy also has helped ameliorate some supply-side issues, while crucially European banks look well placed to see a spurt in working capital loans and trade finance, as the red dragon opens up for business.
However, what's primarily driving interest in European banks is the rate hike narrative and what this has done for the net interest income trajectory, particularly for the Southern European-based financials which have a strong variable rate portfolio. It does not look like the ECB's hawkish ambitions are going away any time soon, particularly when it has expressed concerns over the outlook of wages which are expected to trend up in the months ahead.
While the ECB is more certain, things are a lot iffier with the US Fed, and it's questionable if rates will stay too high for too long. This has reflected poorly on the dollar, even as the allure of European assets has only improved. With European financials likely to have over EUR30bn of funds to distribute to shareholders, you can understand why interest may have perked up with the assets here. I may be digressing here, but speaking of the dollar, it may be losing ground at the moment, but if anyone is thinking of dismissing it altogether, I would urge them to think twice as it still continues to be an integral component of central bank reserves across the world.
EUFN also may continue to see some interest from investors who rotate resources between different banking regions across the world. In a recent Lead-Lag Live Podcast episode with Richard Christopher Whalen we touched upon some of the US banking sector fundamentals. He expressed concerns over how 2023 could be a net negative environment for banks and how these entities would have a difficult time originating new assets.
While conditions look largely positive for European banks, investors also should be aware of some of the risks that come from the global operations of some of the major holdings. Take, for instance, EUFN's largest holding - HSBC. In Q3, its expected credit loss charges rose by 48% on a sequential basis, and much of this was driven by some of the commercial real estate risks in Asia. A slowing GDP runway in Europe too should bring some increased credit risks. Having said that, it’s worth noting that DBRS Morningstar feels that the NII tailwind will likely offset asset quality risks in 2023.
Conclusion
As noted in The Lead-Lag Report, while the performance across the European equity landscape has been encouraging, there comes a point where one does wonder if conditions look overbought in the short term. When I look at EUFN's strength relative to its US counterparts, the long-term ratio suggests there is still a lot of ground to make up. However, investors should also consider that the RSI indicator looks extremely over-extended and is at levels not seen over the last five years. Tread cautiously.
For further details see:
EUFN ETF: Key Themes