2023-06-08 12:27:00 ET
Summary
- EUFN's returns over the long term have been underwhelming, but there appears to be a recent shift.
- European banks are expected to benefit from favorable net interest income trends, low credit costs, and stable funding bases, leading to a decent return on equity expansion.
- EUFN's holdings trade at a significant discount compared to US financials, but we would urge investors to wait for a pullback on the charts.
Introduction
As the name implies, the iShares MSCI Europe Financials Sector ETF ( EUFN ) offers investors exposure towards financial stocks based in Europe. This product has been around since early 2010, but it's fair to say that it hasn't done an overly great job in wealth creation. Over the last 13 years, it has managed to eke out only aggregate gains of 34%, a long shot from what a portfolio of global financial stocks has delivered (IXG with 111% returns), or even what its financial counterparts here in the US have delivered (XLF with 244% returns).
However, this year, we've seen a shift in this long-standing narrative as the regional banking crisis in the US has left investors scurrying away from the domestic options; for context, on a YTD basis, EUFN has managed to deliver double-digit returns. Meanwhile, global financials have only delivered modest gains.
Could this outperformance carry on, more so as EUFN has the making of a potential long-term mean-reversion candidate? Even though there's been a recovery from the record lows, the two images below help contextualize how oversold European financials look versus both their US counterparts (image 1), as well as their global counterparts (image 2)
Well, we couldn't say with any certainty if this outperformance will continue, but there's no doubt there are plenty of tailwinds supporting EUFN.
The Fundamentals Are In Decent Shape
As global and EU growth slows , it is fair to expect cyclical sectors such as financials to lose some of their allure, but we still feel that European banks have enough in their tank to whet the appetite of investors.
A survey held by the World Economic Forum last month highlighted that 82% of the survey respondents (economists basically) expect interest rate rises to slow on account of financial stability concerns. Well, if you ask some of the noted members of the ECB's governing council, it appears that we're nowhere close to seeing a pause. Madis Muller has suggested that we could see rate hikes at least a couple more times, whereas Joachim Nagel does not believe we will reach an interest rate peak in the summer, but rather believes that "several more rate hikes are still necessary".
These comments of course will be music to the ears of those who focus on the NII (Net Interest Income) trajectory of European banks as their asset base continues to get repriced at higher levels. Admittedly, these banks will also face some pressure on the funding side. According to the European Banking Authority's survey, 57% of EU banks planned to offer increased rates on retail deposits (versus 20% in the previous survey), whilst 68% of the banks planned to offer higher rates on customer deposits (versus 30% previously).
All in all, even though deposits are expected to be repriced at higher levels, European banks are still expected to benefit from favorable NII trends this year and next. According to S&P Global , 92% of Europe's 25 largest banks will also witness NII YoY expansion in FY23, and 65% of these banks will witness further NII YoY expansion in FY24 as well!
Granted, given a deteriorating growth outlook and cost-of-living challenges, there could be some deterioration in the asset quality of these banks, but loan loss provisions across Europe have already reached normalized levels, and are not expected to spike from current levels. In effect, credit costs as a percentage of loans are expected to hover near low levels of just 0.25% in FY23.
All in all, the boost in NII, and relatively low credit costs should set these banks up nicely to deliver decent ROE (Return on Equity) expansion. S&P Global expects European banks to deliver ROEs of 7%, up from 6.3% in FY22.
Quite unlike their US counterparts, we also feel that European banks have a more stable and reliable funding base. We're essentially referring to the heightened chunk of retail deposits in the funding structure of most European banks. These deposits are not capricious in nature and are less prone to outflows. A large component of these retail deposits are also covered by deposit guarantee schemes, which helps mitigate the risk of bank runs, and brings a strong degree of reliability in the ecosystem.
Also note that whilst European banks are required to meet a minimum Liquidity Coverage Ratio ((LCR)) of 100% to cope with potential liquidity outflows (this ratio helps shed insight on how much cash-like assets these banks hold), the actual ratio is a lot higher, at around 160% . Conversely, in the US, the LCRs of banks there are typically a lot lower at 120% or so.
Closing Thoughts - Technical And Valuation Angles
Whilst the fundamentals look largely encouraging, what tilts the equation even further is the dirt-cheap forward valuations relative to US financials. According to YCharts , EUFN's holdings currently trade at a forward P/E of just 8x and a forward P/BV of less than 1x (0.91x to be precise); this translates to a roughly 40% discount, both on the P/E and P/BV side, if you consider XLF 's corresponding multiples.
Then, if one analyses the long-term price imprints of EUFN on the monthly chart, we can note that over recent years, there's been a contraction in its trading range, so much so that both the upper and lower trendlines appear to be moving to some form of symbiosis; put another way, you're staring at something akin to a symmetrical triangle pattern which can often prove to be a tricky pattern to trade as the probability of both breakouts and breakdowns are not too different.
EUFN now appears to be consolidating just below the upper triangle boundary for the last six months and may break out from here. However, do consider that something similar happened between April 2021, and February 2022 where the stock consolidated just below the upper boundary but eventually failed to find a requisite trigger to facilitate a breakout.
There's a chance we see that scenario play out yet again, hence we believe investors would be better-positioned to cope with a potential failed breakout risk by waiting for EUFN to pull back to the sub $20 levels before considering a long position.
For further details see:
EUFN: Much To Admire About The European Financials ETF, But Not Yet A Perfect Buy