Investment Strategies
GUEST COMMENT: Higher Rates Will Be Positive For Europe's Banks, Says Pictet

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.