UBS: Why not to fear financials

The MSCI Europe Financials equity index is down by 20.2% year-to-date, and US financials have fallen 12.8% in 2016.

Credit default swaps on European subordinated bank debt are trading at 268bps, after breaching 300bps, which was the highest level since March 2013.

Behind the rout appear to be three main concerns:

Asset quality may be deteriorating, particularly given the weakness in oil and commodity prices, and signs of a slowdown in economic growth.

The yield curve is flattening. The difference between three-month deposit rates and 10-year lending rates in the US is now at its lowest level since August 2012, and approaching early 2015 lows in the Eurozone, indicating future pressure on bank net interest margins. This could grow more problematic if central banks cut interest rates into negative territory and commercial banks are unable to pass these through to consumers.

Credit conditions are tightening, raising the risk of a self-perpetuating spiral of tighter credit conditions, problems refinancing debt, and consequent difficulties for seemingly sound banks.

However, we believe the current stresses are overdone:

Exposure to the energy sector is manageable (average 5% commodity loans/total loans exposure for European banks) and, unlike in the sub-prime crisis, the debt is generally not repackaged and/or re-leveraged. Even in a stress scenario of 50% of sub-investment grade commodity-related loans becoming non-performing, the capital impact for European banks should prove manageable. Furthermore, there is presently no clear evidence that the global economy is headed for recession. CIO is forecasting real GDP growth this year of 1.6% for the Eurozone and 1.5% for the US.

Eurozone banks have improved capital ratios since the sovereign debt crisis, so any deterioration in asset quality should have less of an impact than in the past. The average capital ratio among the major listed European banks has risen to 12.6% in 1H 2015 from 9.7% in 2008, and the vast majority of European banks have already reached 2019 capital requirement targets.

Valuations are already discounting weak profitability in any case. The European sector’s 0.6 times price/book value is comparable to 2008–12 valuations. In the US, large multinational banks are trading at a 33% discount to the S&P 500, below 10x forward price-to-earnings.

Central bank emergency provisions are still available. Banks in urgent need can exchange collateral for liquidity through the funding windows of the US Federal Reserve and European Central Bank.

Of course, banks are still inherently leveraged businesses, reliant on external confidence and funding. Investors will need to prepare for near-term volatility, and remain selective in their approach to investing in financial capitaland equity. But we believe the system as a whole is not at significant risk. Within equities, we remain overweight European financials and market weight the US, where we favor the large cap multi-national banks over diversified financials and insurance companies. Within investment grade credit, we favor senior unsecured bonds for banks with the most stable credit profiles. US senior unsecured bonds remain less challenged relative to their European peers, as the largest US banks benefit from a more unified regulatory environment and from having met fully phased in capital, liquidity, and leverage requirements.

Author: Kiran Ganesh, UBS Global Investment Office

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