The key chart

**Banks play catch up since 18 May 2020, but what kind of rally is this and can it be sustained?**
Source: FT, CMMP analysis

Summary

The SX7E index of leading European banks bounced 38% between 18 May and 5 June 2020, outperforming the broader SXXE index by 15%.

Among the index “heavyweights” (by market cap), the biggest share price gains corresponded with the largest previous YTD share price falls – BNP Paribas, ING, Unicredit and Soc Gen. Trading volumes also rose from recent lows but remained below those seen during March’s sell-off.

The rally took place (1) two months after the broader market, (2) despite a worsening operating environment, and (3) in the absence of the macro building blocks required for a sustained recovery in sector profitability.

It coincided with the announcement of the EC’s proposed €750bn “Next Generation EU” fund and can, therefore, be seen best as a vote of investor confidence in the policy response rather than a fundamental shift in banking sector dynamics (note parallels with the performance of the oil and gas sector).

Looking forward, the limited progress in dealing with the region’s private sector debt overhang still clouds the LT investment perspective. High debt levels explain, in turn, why money, credit and business cycles in the EA were already significantly weaker than in past cycles, why inflation remains well below target, and why rates were expected to stay lower for longer even before the Covid-19 pandemic hit.

Last week’s ECB forecasts indicate that the growth recoveries expected in 2021 and 2022 will not make up for the 8.5% real GDP contraction this year. Weak pre-provision profitability levels represent the key challenge facing EA banks in terms of addressing the associated challenges and suggest that the MT investment perspective also remains negative.

A positive investment case rests, therefore, largely on valuation (ST investment perspective). Banks established new support levels in terms of absolute price at distressed valuation levels (0.2-0.4 PBV). Despite rallying off these levels, share prices of large EA banks typically remain 20-30% lower than at the start of the year and valuations low in a historic context.

Bank valuations remain low/distressed in absolute terms and versus historic trends. Conviction in the current rally and sector outperformance is challenged, however, by the lack of alignment between the three investment perspectives that form the basis of the CMMP analysis investment framework.

In my view, the true value in analysing developments in the financial sector remains less in considering investments in developed market banks and more in understanding the implications of the relationship between the banking sector and the wider economy for corporate strategy, investment decisions and asset allocation.

As before, the key message from the money sector here, is the importance of the EC’s proposal for the “Next Generations EU” fund. Investment returns, including the impact of country and sector effects, will be driven to a large extent by how this debate concludes, as will the future of the entire European project.

Please note that the summary comments above and the graphs below are extracts from more detailed analysis that is available separately.