A turn in the trend for interest rates would provide much-needed relief for Europe's banks, argues this Swiss wealth management house.

A rise in interest rates will be positive for Europe’s banks, argues Yann Goffinet, senior financial analyst at Pictet Wealth Management, the Swiss private banking house. In recent years, a period of low, or even negative, real interest rates (such as in Pictet’s home country) have hit banks’ margins, and forced investors up the risk curve in the chase for returns. Goffinet sets out his reasoning on why a move towards perhaps more normal interest rates will be beneficial. The editors of this news service are pleased to share these comments; they do not necessarily share all views of guest contributors and invite readers to respond. They can email tom.burroughes@wealthbriefing.com.
 
The market performance of European banks in 2016 was a tale of two halves. In the first half, banks were the worst-performing sector on the Stoxx Europe 600 index of equities. This was a period during which the European Central Bank embarked on a new quantitative easing scheme and the British decided to leave the European Union in the Brexit referendum, both factors contributing to ever-lower interest rates throughout Europe.

But in the second half of the year, banks recovered most of their first half underperformance as bond yields rose from their July lows on both sides of the Atlantic, in line with improved economic data. In the US, the recovery in bond yields has been further boosted by the election of Donald Trump. There was a high correlation between the European banks’ relative performance and inflation expectations during 2016. An equally good correlation could be shown between European banks’ relative performance and US bond yields.

Imagine a simplified world with interest rates of 3.5 per cent, while retail banks pay 2 per cent for client deposits. In this world, banks pocket the 1.5 per cent difference as part of their net interest margins. But in a different scenario, where interest rates drop below 1.5 per cent, as banks are reluctant to charge customers for depositing money at the bank, their margins on deposits start to shrink. Should base rates turn negative, then banks are potentially facing negative deposit margins. This is the situation in which European banks found themselves in 2016, especially after the ECB slashed its own deposit facility rate to - 0.40 per cent in March.

On the lending side, margins have held up better. However, euro area banks have generally been unable to offset lower deposit margins through rising loan margins (unlike banks in Sweden and Switzerland). The flattening of the yield curve that has accompanied the ECB’s QE has further dented bank margins. Given that banks’ assets are of longer duration than their liabilities (loans tend to be of longer maturity than deposits), a flattening of the yield curve leads to less interest revenue.

In combination with rising capital requirements since the financial crisis, this pressure on net interest income, which remains euro area banks’ main source of revenues (about 60 per cent) has led to low returns on equity. The average ROE in the European banking sector stood at about 5 per cent in 2015/16. This compares with an average ROE for Stoxx Europe 600 companies of 12.5 per cent. Put another way, with negative rates and flat yield curves, banks cannot cover the cost of their infrastructure (IT, branches, staff) and make double-digit returns at the same time.

Hence, the turn in interest rates and inflation expectations during the second half of 2016 came as a relief for European banks, putting to rest some of the worst fears about future profits. From a valuation standpoint, the price-earnings multiple at which banks trade relative to the overall equity market moved from 0.6x in summer 2016 back up to its historic average of above 0.8x in a matter of a few months.

The speed of banks’ recent re-rating suggests that most of the easy reflation trade may have happened already. Even if the re-rating proceeds and banks’ relative P/E multiples move higher than their long-term average, a wave of earnings upgrades may be needed to support the performance of the European banking sector from here on (so far, earnings have simply bottomed out after a long period of decline).

The coming months will clarify if the optimism on growth and interest rates, particularly evident since the election of Trump, is justified. Still, global interest rates may well have seen a low in 2016, so that the environment for banks going forward may steadily become less challenging and normalise. Such a development would justify selectively increasing portfolios’ exposure to banks. Banks with exposure to the US, the market that is driving the upturn in interest rates, may remain attractive - at least as long as the ECB continues with its QE programme.