Description

The headline for the investment pitch here is UniCredit but the overall thesis is really applied to the broader European banking complex.  As we stand today, European banks have rallied 50%+ since October but on absolute levels, are still trading at 30% above post GFC lows.  Just to contrast, banks in US as reflected by KBW is 500% above March GFC lows and trading close to March 2007 levels.  Banks in Europe currently trade at 0.7x P/B and ROE of 8% - valuations are the lower end of the historical range.  European banks have always been cheap – so what has changed and why now? At a high level it’s really driven by weather and rates.  If you rewind the clock to summer of 2022, the consensus was that Europe was going into a big deep recession in 2023 as the energy disruption from Russia/Ukraine conflict would drive up energy costs materially which would ultimately cut deeply into consumer disposable income as well as into industrial corporate profitability.  Given big recession, banks would ultimately be hit as ECB would be forced to keep rates low to stimulate the economy and losses would mount up given deceleration of economy. Fast forward to October/November, the weather was much warmer than anyone expected, gas storage is almost at 100% in EU while energy prices collapsed back to pre-Ukraine levels.  In addition, the ECB has much more hawkish than markets had expected with rates expect to reach 3.2%+ by summer of 2023.  Given these developments, banks re-rated by 50% from the bottom.

Despite the move, we think there is significant more upside driven by three drivers: further increase in NIM/NII; capita return and valuations.  As we look at rates, ECB is expected to raise rates to 3% by summer.  NII growth has gone from negative on a YoY basis between Covid and Q1 ’21 to sequentially positive #s thereafter.  NII has inflected from +1% in 2Q21 to +23% in 3Q22.  As rates continue to get passed through (with a lag), NII will continue to accelerate.  Just a reminder, rates in Europe were at negative levels last year – as a result, with most banks’ BS reset to negative rates, the inflection from negative to positive rates, even if moderate, is very significant from a profitability level.  If you run through the math, NIMs which bottomed at ~200bps for many could inflect upwards by another 50bps – even assuming lower NIM expansion, profitability could be 50% higher given improvement in ROA and ROE. For more interest levered banks, profitability could inflect upwards of 100-200%.  You are seeing a reflection of this in the most recent earnings announcements – European banks have gone through 9 consecutive quarters of earnings upgrades. In the most recent quarter, many banks have surprised consensus estimates to the upside by 30-50%.  Furthermore, asset book for most of these banks are saddled with securities that have priced in 3-5 swaps in a low interest rate environment earning less than 100bps in rates. As rates normalize and maturities roll over, these securities will reprice at the prevailing much higher rates which will again flow through 100% to the bottom line. 

The second underappreciated aspect is that banks in Europe are transitioning from a period of capital accumulation to that of capital return. Over the past 10+ years, banks in Europe for a host of reasons have were in constant restructuring mode and raised significant equity between 2010-2018. As such, capital ratios have doubled since GFC with CE Tier 1 ratios at 12%+ while they have also reduced the aggressive lending to higher risk pockets in this last cycle.  From a regulatory point of view, EU regulators have been much conservative and did not allow many of the banks to release the reserves they had built during the pandemic. As such, EU banks have on average only released 1/3 of the capital while US banks released close to 90% of those unutilized reserves.  As a result, most of the banks in Europe are overcapitalized while the risk to their portfolios have been reduced given EU is not expected to go into a recession this year.  As such, median European bank is expected to return no less than 25% of their mkt cap in dividends or buybacks in the next three years. 

Lastly, valuations continue to be undemanding in Europe.  Banks trade at 7-8x 23 EPS and 6-7x 24 EPS (even lower depending on one’s NII expectations).  As earnings continue to surprise to the upside, we expect banks will get re-rated to historical average multiples. 

Catalyst

Continue rate increases + captial return + rerating.