Philippe Bodereau, Flavio Carpenzano
Flavio Carpenzano, credit product specialist in PIMCO’s London office, talks to Philippe Bodereau, PIMCO’s global head of financial research, about the outlook for the European banking sector in 2017.
Flavio: Philippe, at the start of last year there was a lot of concern about banks’ profitability. Do you think the scenario has changed in 2017?
Philippe: Yes, I think a number of things have changed in terms of the macro backdrop. About a year ago, we were in the centre of the storm with bank equities in particular. The key reasons for that were fear of deflation and the belief that the ECB was going to stay lower for longer, if not forever. These fears have now firmly receded.
You can see this in the steepening of the yield curve, which actually started in the summer but gathered speed with President Trump’s election. It continued with the announcement of the ECB tapering – they don’t like to call it that, but that’s effectively what happened when the ECB announced it would reduce the amount of bonds it purchases from €80 billion a month to €60 billion (although it extended the programme by nine months). In conjunction with better PMIs, and better GDP growth, that really changed the outlook for bank profitability.
A second point on bank equities is the regulatory cycle is slowing down. For instance, Basel IV will likely be less punitive than expected, and I think that’s a relief for shareholders.
Flavio: Banks have also faced a lot of litigation risk since the financial crisis – with around $300 billion in litigation and conduct costs since 2009. Do you think litigation risk is behind us or will more skeletons come out of the closet?
Philippe: I don’t think there’s a huge amount of new things to come out of the closet, but there is a lot of unfinished business. There have been some large settlements recently, which is a positive, but there is still litigation in the course of being negotiated. There are also a few banks where settlement actions are running late. However, the banks we see as most vulnerable have strong capital bases and should be able to absorb even substantial charges.
Flavio: Italy has been a drag on the outlook for European banks for some time. But since December we have started to see positive developments, with the government approving €20 billion of public funds to stabilise the most fragile institutions. What’s your view on Italy?
Philippe: We’re marginally more constructive. However, within the peripheral European banking systems, we’ve expressed a strong preference over the past few years for Spanish and Irish banks versus Italy. And that remains the case today.
A big change towards the end of last year was a private placement of AT1s by UniCredit, in conjunction with a large capital increase and the sale of some non-performing loans (NPLs). This is a game changer for the Italian banking system: It is the first time we’ve seen a proper marking-to-market of bad assets – something that happened in Ireland and Spain two or three years ago. It’s the first sign of putting a floor on the valuation of those bad assets, and that’s important.
It’s also the first coherent plan we’ve seen. In general, we know what works well for banks with a large burden of NPLs. They need a solution for raising capital and a solution for dealing with bad assets. It’s a big positive that we have an example of a plan addressing both for the first time in Italy.
I also think it’s positive that the market is beginning to separate banks that are viable from those that are non-viable. By non-viable I mean banks that will not be able to attract private-sector capital to recapitalise themselves and will need some form of government or state support.
So overall, Italy has taken a major step in the right direction, but it’s still a work-in-progress and remains one of the most challenged banking systems.
Flavio: One issue we hear a lot about from investors is political risk. What’s your view on upcoming European elections and their impact on banks and the credit market in general
Philippe: What 2016 teaches us is that, first of all, we should be very humble about making political forecasts, and second, even if you know what is going to
happen, chances are you will still make a wrong decision. So you need to take a long-term view in this kind of environment and remain invested.
The reason is if you’d told most people at the start of 2016 that Brexit was going to happen, Trump was going to win and Renzi would lose his constitutional reform referendum, you probably wouldn’t have bet on positive returns for equity and credit markets.
With regards to Europe, where the election calendar is intensifying over the next few months, the French election will be by far the most heavily watched. We’ve already started to see volatility in the OAT (French government bond) market, and I think that could continue.
How do we think about this? We don’t rely on the polls because they can be inaccurate. If you look at polls today, from a purely statistical perspective, the chance of the far-right leader Marine Le Pen winning the presidency is close to 0%. That seems a foolish way to think about it. So we are working on the assumption that there is a chance (albeit small) of Le Pen winning.
How do we position for that? We have fairly limited exposure to French banks and more exposure to non-eurozone countries, such as the UK and Switzerland, which in relative terms should do better in the event of a surprise election outcome in France.
Also, volatility isn’t always a bad thing – we have high levels of cash and will take advantage of opportunities to pick up attractively priced assets in the run-up to the election.
Flavio: Can you give some more colour on other countries and where you see opportunities in financials today?
Philippe: One thing that remains striking is the disconnect between valuations in the U.S. and Europe right now. In the U.S., the risk premium for subordinated debt is extremely low; the difference between senior unsecured debt and subordinated debt is about 40 basis points, and the spread between subordinated debt and preferred is 80 basis points, which is not very much. As a result, in the U.S. banking sector last year, we favoured long positions in senior debt.
Post-Trump, we’ve sold out of our U.S. bank equity positions within our capital securities strategies. There’s been a very big rally – over 20% in U.S. bank equities – and we feel we need to wait and see what actually happens on the policy front. More importantly, I think it’s good discipline to take profits given that multiples for U.S. banks – whether price-to-earnings or price-to-tangible-book-value ‒ are the highest we’ve seen since the financial crisis.
The UK, Switzerland and Spain remain a few of our favourite countries. In Spain, senior debt trades at tight levels; recently, the largest banks have been able to issue five-year senior debt at Libor plus 50 to 60 basis points. That’s important – it means the market believes the risk of default is extremely low. Then if you look at the bottom of the capital structure, Spanish bank equities command some of the highest multiples in European financials, which is a strong signal that the stock market views these
banks as commercially viable and attractive.
Yet, despite those strong signals at both ends of the capital structure, hybrid securities are trading at yields of 8%‒8.5%. We think there’s a big pricing anomaly here, and that’s just one example.
This Q&A is an extract from a webinar recorded on 9 February 2017. To listen to the full conversation click on the link below.
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