In April 2011, Breakingviews columnists Christopher Swann and Peter Thal Larsen assessed that after years of unrest, the time was right for investors to wade into the European banking sector. Citing a round of recapitalizations and perceived clarity around regulations, the columnists hypothesized in The New York Times that with Europe’s investment banks trading at around book value, investors were facing a “buying opportunity that may not be repeated.” Roughly a year later, The Wall Street Journal’s Jack Hough, drawing attention to even sharper discounts, addressed the same perceived opportunity in a headline that asked, “European Banks: Is Now the Time to Take the Plunge?” And a year after that, it was CNBC’s turn, with a headline that pronounced “European Banks Haven’t Been This Cheap Since [the] 80s.” It was the poet William Cowper who famously wrote that a fool must now and then be right by chance; but in this case, when it comes to the European banking sector, it may be a decade or longer before chance finally proves these predictions true.
A classic value trap usually involves one stock and can catch even the most sophisticated investors. Consider the case of teen fashion retailer Delia’s. Several well-known hedge funds — many with otherwise sterling track records — began accumulating shares of the retailer ahead of the 2013 holiday season. The chief driver was the stock’s valuation, which that November sat at roughly 0.25x sales and 1.5x its book value. Investors were also emboldened by other catalysts such as a new CEO and the sale of a subsidiary, which freed up needed capital. It wasn’t until the company folded this past December that investors finally concluded that the stock was overvalued when they first got in more than a year earlier.
Occasionally, an entire sector can represent a value trap, which makes discovering such an ambush even more challenging, as investors may approach the market as a zero sum game made up of only winners and losers. While pundits and investors are keen to predict a bottom for the European banking sector, we believe a host of disagreeable circumstances are conspiring against the market and will serve to blanket growth and value creation for the foreseeable future. In cases like this, it’s more constructive to look not at historical metrics but rather at history. And investors who may want to “take the plunge” in Europe’s banking sector should first consider the barren, descending path navigated by those who thought they were finding value investing in Japan’s banks some two decades earlier.
Analysts at Berenberg published research in February that drew some striking parallels between the European banking market today and that of Japan in the early 1990s. The analysis, through comparing the economies, demographics, banking systems, and policy responses of 1990s Japan with that of modern-day Europe, paints a discouraging picture for European banks. As well, this picture falls against the backdrop of a structural bear market that Berenberg analysts expect to prevail for the foreseeable future.
For Europe, as with Japan, this prolonged trough begins with a concluding 70-year debt cycle that at its peak served to bring forward future consumption and, with its end, produced what economist Richard Koo termed a balance-sheet recession. A balance sheet recession — largely immune to fiscal policy actions — results when asset prices collapse as credit dries up, leaving private-sector balance sheets with liabilities that exceed the value of assets. Berenberg believes that following the Japanese archetype, Europe’s private sector will attempt to delever their balance sheets, but this could have the effect of producing large-scale deficits in the public sector as policy makers seek to stave off deflation. When Berenberg marries its analysis around debt with the anticipated deflationary environment, the firm posits that nominal GDP in Europe could show little to no growth for years to come, with interest rates entrenched at close to the zero bound.
What this Means for Europe's Banks
First, more cynical observers believe that bank balance sheets continue to hold concealed loan losses. Back in October, most marketwatchers focused on the 25 banks that failed the ECB’s stress test, but perhaps more concerning was the separate asset quality review that turned up nearly $175 billion in non-performing exposures. Moreover, Berenberg notes that flat yield curves at the zero bound will impact net interest margin and pressure fee income, particularly payment and lending fees. The stagnant economy, coupled with demographic trends such as an aging population, is only expected to further hit asset quality. For these and other reasons, Berenberg predicts that balance sheets will continue to contract and loan/deposit ratios will fall materially below 100 percent. Fixed income assets, if their forecast holds true, will grow significantly as a proportion of assets, while non-performing loans continue to grow and loan-loss charges stay historically high.
While these factors would be challenging in isolation, when taken together and superimposed over similar trends that preceded Japan’s decades-long banking slump, the parallels can be downright discouraging. Indeed, Japanese banks peaked at around 4x price to net asset value (P/NAV) in the early 1990s and, following a steady descent, settled in at roughly 1x P/NAV; they’ve since traded at or below this level for more than ten years. European banks, in 2007, shared a similar valuation peak and have only recently gravitated to the levels of Japanese banking stocks. If European banks are to avoid the fate of their peers in Japan, they will need to improve capital levels and credit quality and, at the same time, generate asset growth, which is a tall task in even healthy markets.
From our vantage point, the odds appear to be stacked against them, particularly given the lack of stimuli available to the European Central Bank, even as the ECB began its $1.3 trillion quantitative easing program in March. Japanese short-term interest rates peaked in 1991 and fell to their effective zero bound by the early 2000s, where they have remained fixed, lest threaten continued efforts to rebuild the economy. European interest rates have followed a similar path and recently joined Japan at the effective zero bound level.
To be sure, even in this environment, long-term winners will likely emerge. As bottom up investors, however, our analysis has yet to find any candidates whose current stock prices in the risk and uncertainty we see. While there may be one-off catalysts that can provide temporary support to share prices, when we dig into the fundamentals and try to build faith around bank balance sheets, we’re left with an inclination to keep a safe distance. Moreover, while QE can temporarily buttress sentiment for European banking stocks, we still struggle to find fundamentally strong companies with sustainable business momentum in Europe’s banking sector today.
Consider Unicredit S.p.A, which in December said it wouldn’t book any write downs due its exposure to Russia. In February, however, as part of its earnings announcement, the Italian bank reported that its assets in Russia and Ukraine lost €1.1 billion, leading its common equity tier 1 ratio to fall 28 bps to 10.02%. This is another instance in which we have trouble building any confidence around the balance sheet, making the stock’s 0.67 price-to-book ratio (MRQ) appear to be a classic value trap.
The largest 20 banks in Europe by market capitalization (excluding the UK) are generating a 6.8% ROE and trading at 1.2x price to book value. The largest 20 banks in Japan, meanwhile, are generating a 7.0% ROE and trading at 1.1x price to book value. This same group of 20 banks in Japan have traded at an average of 0.80x price to book value for the last 10 years. It’s a chilling prospect to consider that this could be the fate of Europe’s banking institutions in 2025.
Boston Partners is a dba of Robeco Investment Management, Inc., an investment adviser registered with the SEC under the Investment Advisers Act of 1940. The views expressed in this commentary reflect those of the author as of the date of this commentary. Any such views are subject to change at any time based on market and other conditions and Boston Partners disclaims any responsibility to update such views. Past performance is not an indication of future results. Discussions of market returns and trends are not intended to be a forecast of future events or returns.
Joshua Jones is an Associate Portfolio Manager for Boston Partners Global and International strategies and an Equity Analyst