“Macro building blocks revisited”

The key chart

Summary

In early September 2019, I outlined the five key “macro building blocks” that drive bank sector profitability and share price performance (see “Macro building blocks matter”– look at the SX7E). I highlighted how they had weakened significantly during 2019, and noted how this had been accompanied by poor absolute and relative performance of the SX7E index of leading European banks over the previous twelve months.

Since then, the SX7E index has risen 26% from its 15 August low of 77 to a recent high of 97, before falling back to 93 currently (6% lower than 12 months ago). In this short update, I consider this performance in the context of my macro building block framework to ask: is this a relief rally or the start of a period of sustained recovery and share price outperformance?

Macro building blocks recap

In developed economies, I focus primarily on five key “macro building blocks” that drive bank sector profitability and share price performance:

• growth in real GDP
• growth in private sector credit
• the level of ST rates
• the level of LT rates
• the shape of the yield curve

Net interest income – the main value driver for most banks – has a positive relationship with GDP, the level of rates and the shape of the yield curve. The level of ST rates is more important for banks in “floating rates” economies and market segments. In contrast, the slope of the yield curve is more important for banks in “fixed rate” economies and market segments.

In the Euro Area, 63% of new loans to HHs and NFCs are based on variable rates but only 18% of mortgages (down from 58% in November 2004). This means that EA banks are affected by both the level of ST rates and the slope of the yield curve.

Non-interest income – the second key value driver – has a positive relationship with GDP but a negative relationship with the level of ST rates, while provisions have a negative relationship with GDP and a positive relationship with the level of ST rates.

Building blocks revisited

Real GDP growth has slowed from the recent high of 3.0% (4Q17) to 1.1% (3Q19), the weakest rate of growth since 4Q13 and below the region’s twenty year average of 1.4%. All of the major Euro Area economies are growing below their LT averages with the exception of Spain and Portugal.

The European Commission revised down its 2019e, 2020e and 2021e GDP forecasts recently to 1.1%, 1.2% and 1.2% respectively. The latest ECB forecasts are the same for 2019e and 2020e, but they see growth returning to the LT trend of 1.4% by 2021e. These forecasts are consistent with monetary sector indicators (see “Look beyond the yield curve II”)

On a more positive note, private sector credit growth remains at/close to the highest level in the current cycle. The 3m MVA of PSC, NFC and HH YoY credit growth were 3.7%, 4.0% and 3.4% in September 2019. However, these growth rates remain subdued in relation to past cycles, concentrated geographically and increasingly directed towards less productive segments (see “Fuelling the Fire – the hidden risks of QE)

ST rates remain locked at the base of the ECB’s corridor (-0.46%) and the Governing Council “now expects the key ECB interest rates to remain at their present or lower levels until it has seen the inflation outlook robustly converge to a level sufficiently close to, but below, 2%”.  This is negative for net interest margins in those countries (Austria, Italy, Portugal and Spain) and market segments (NFC lending) that are characterised by floating rate lending

LT rates have recovered from their lows but remain in negative territory. Ten year bond yields have recovered from the August lows of -0.71% to -0.26%, but are 49bp lower than at the start of the year.

The EA yield curve has steepened 42bp from its recent inverted low (-0.28%) and moved back into positive territory at 0.14%. This is still 40bp flatter than at the start of the year which has negative consequences for net interest margins in countries (Belgium, France, Germany and the Netherlands) and market segments (HH lending) that are more exposed to fixed rate lending.

Negative ST rates and flat yield curves are compounded by on-going price competition. On-going narrowing of spreads has been a key feature of the HH sector. Over the past twelve months the spread on new HH loans has fallen 24bp from 2.13% to 1.89%. In contrast, the spread on new NFC loans has remained relatively constant at 1.77%.

Sustained recovery?

European banks continue to generate a lot of noise but little overall direction. The recent rally in the SX7E index is consistent with less negative bond yields and the end of the period of yield curve inversion. Nonetheless, current macro building blocks are not sufficient to support a sustained recovery in banking sector profitability across the region, in my view.

The purpose of this website is not to make investment recommendations (and ignores valuation), but my analysis suggests that the recent rally in European banks share prices represents a relatively ST relief rally rather than a period of sustained recovery and outperformance.

Please note that the comments above are abstracts from more detailed analysis that is available separately.