UK and European economies have reached a turning point, meaning domestic stocks will perform well and banks will thrive in the face of adversity, according to S.W. Mitchell Capital’s Stuart Mitchell.
The FE Alpha Manager, who is managing partner and chief investment officer of the firm, reasons that interest rates have less of an impact on banks than many investors believe.
The banking sector has remained unloved by many UK and European investors since the financial crisis of 2008, due to concerns that they’ll be hit by regulatory fines and are susceptible to macroeconomic headwinds.
Since the throes of the crash, the FTSE UK Banks index has lost 29.76 per cent while the FTSE All Share has returned 64.37 per cent.
Performance of indices since 2008
Source: FE Analytics
Now, given today’s ultra-low interest rate environment, many investors believe banks will struggle to gain capital and pay out dividends.
In an article published last Tuesday, CMC Market UK’s Michael Hewson warned the outlook of banks is unlikely to improve from here given the low interest rate environment, restructuring costs and litigation fines.
“The sharp fall in the share prices of the UK banks in the aftermath of the Brexit vote has shown little signs of being reversed and the outlook probably won’t have improved too much given the cut in UK interest rates that followed in August, which flattened the UK yield curve even further,” he said.
However, S.W. Mitchell Capital has held a significant weighting in banks – which currently stands at around 15 per cent – across its portfolios for more than three years and these positions have been added to throughout the course of the year.
One of the firm’s largest weightings is Lloyds, which Mitchell says many investors are bearish on because they think non-performing loans will increase and banks are going to be hit hardest.
However, he points out the firm has actually revised its earnings forecast upwards since Brexit and the management team is more optimistic that it was last year.
“[People are also concerned about] regulation. There’s still a feeling that it’s a never-ending story -banks are somehow being asked to hold more and more capital so they’re not able to pay out dividends or their dividend pay-outs are postponed,” he said.
“We think it’s gone as far as it will go. At the end of the day, banks now have to hold five times as much capital as they had to hold before the crisis, that’s quite a lot. It’s pretty significant.
“We’ve got to a stage where the politicians have stepped in and said: ‘What we’re doing is really affecting economic growth, I think we’ve got about as far as we’re going to go.’ We expected it to be round about where it is and we don’t expect it to go much further.”
The CIO also says lower interest rates don’t impact banks to the extent many investors think they do.
He argues that most banks have been able to offset this through their funding structure. For instance, he points out that Lloyds has offset low interest rates through widening loan spreads.
That said, he warns some regions are higher risk than others for those looking to buy into the banking sector. For instance, the below graph shows the performance of German bunds with a duration in excess of 10 years versus UK gilts. The valuations have increased significantly over the last year, forcing yields lower.
Performance of indices over 1yr
Source: FE Analytics
“Where you face problems is in a country like Germany, where you get an excess in savings and where banks are forced to put money into German bunds,” Mitchell continued.
“You still get a positive yield on a British bond and you get a negative yield on German bunds. There’s this glut of savings in the German banking system which they have to pay for by being invested in German bunds where it’s a cost to hold them. That’s a big, big problem.
“The ECB have gone some of the way to offsetting this by paying banks 40 basis points of their deposit money. [Interest rate risk] is real for the German banks, but again they’re doing a lot to offset that with cost cutting and digitalisation.
“In terms of net interest rates, people exaggerate the effect of that. I think the one thing we’ve been surprised by is that lending growth hasn’t been faster. After most crises you get a pretty dramatic pick-up in lending growth and that hasn’t happened this time.”
The CIO says lending growth is still marginally higher in the UK compared to most countries in Europe, but says the level of capex sales across both regions is at historic lows while the amount of cash on corporate balance sheets is at a historic high.
He says this is because investors have been spooked by geopolitical and macroeconomic uncertainty and are no longer willing to invest.
“You read the newspapers, you read about Trump or Putin or Brexit and, if you’re a CEO and you remember 2007, you just think twice,” Mitchell continued.
“My guess is we’ll still make 50 per cent to 100 per cent on our bank holdings. We bought Lloyds at 25p, it fell to 16p and now we’ve doubled our money. We still think it’s probably worth £1, £1.20. That was our target when we first bought it two or three years ago.
“Intesa Sanpaolo likewise has doubled but we think it will make another 50 to 100 per cent.
“We’ve lost 30 per cent in Banco Popular and Commerzbank, but they’re doing things to offset that. Again, they’re trading at very low valuations. From where we are now we will make three or four times our money.”
However, he says the economy has to gently recover before this happens, which he believes is likely. Before banks reach their full potential, the CIO says there needs to be greater loan growth and interest rates need to gradually start rising to improve sentiment.
“Even if it doesn’t mean anything in reality, it will encourage investors. Investors have the view that higher interest rates are good for banks. It’s just not really true, it’s a very complicated calculation,” Mitchell said.
“In fact, banks are so basic, they really are. They’re nowhere near as complicated as people make them out to be.”