US banks have been an excellent place for income investors to be over the last three years. We have seen strong net interest margin expansion, solid loan growth and provisioning (what banks set aside to allow for impaired loans) at very low levels, while the dividend per share on the SP625 (the sub-group of banks in the S&P 500) has grown by greater than 50 per cent. 
We believe this ‘Goldilocks’ period has now passed and that NIM increases will decelerate, volume growth will start to underwhelm and the provisioning cycle (in part a function of the rate cycle), will trough. In short, we believe US bank returns have probably just about peaked, this cycle.
Having absorbed results from the last two quarters of 2018, our thesis remains intact. True, loan growth and provisions across the US banks, on average, have not shown any clear signs of deterioration. However, during the first quarter of 2019 we saw a trend of customers – particularly consumers – moving funds from non-interest bearing to interest-bearing accounts, driving up costs for banks. This further undermines the narrative of NIM expansion for US banks still held by some market participants.
Together with the Fed’s policy volte face (chairman Jerome Powell now favours a ‘patient’ approach over further rate increases, leading to some forecasts the next rate change will be a cut), a decelerating US GDP outlook and relentless competition in key loan categories, we see potential for further margin disappointment, as well as lower loan growth and rising provisions, especially if bank underwriting discipline follows the path of previous cycles.
The above focuses on key drivers of earnings and incremental returns on shareholder equity in the US bank space. In light of this evidence, and given the uniquely leveraged profile of bank business models, one would ordinarily expect valuation multiples to be at depressed levels. Not so. In fact, we see signs of some banks trading at near peak-premium levels for the period since the dotcom bubble burst. Even with a lift to profitability from the US Tax Cuts and Jobs Act (which reduced the top corporate tax rate), these companies remain deeply cyclical assets, which have sold off massively the past two US recessions. Ten years into a bull market, with earnings growth running out of steam, we believe US banks represent and unpalatable risk-reward output for long-term investors.
Signs of optimism in Europe?
At the same time, is there more reason to be optimistic on European banks? Unlike their US counterparts they are yet to experience their Goldilocks period (high volumes, expanding margins, and very low provisioning). There were signs at the end of 2018 this could be upon us, as Mario Draghi announced the end of quantitative easing and the market began to form expectations for a rate increase in December 2019.
Since then, concerns on the eurozone’s growth trajectory (and therefore credit demand) have re-emerged, and the 12-month Euribor rate – the key reference rate for most European Banks – has started to retrace (having picked up momentum in full-year 2018). Usually a geared play on the economy and the rate cycle, this environment would normally spell trouble for bank share prices, yet year-to-date European banks have traded in line with the broader European index – a sign perhaps that the market is past peak negativity on European banks?
Positives for the long term
Near-term demand and the declining Euribor rate has undoubtedly been disappointing, but long-term investors are often required to be patient. Given where European bank valuations, interest rates (very low) and asset quality (excellent) currently sit, we still see selective positive long-term risk/reward in these assets, especially relative to non-European banks.
We believe several European banks will reach a position over the next couple of years where they will begin to return substantial amounts of capital to shareholders, even if this challenging interest rate environment persists. We remain constructive on the European banks that are able to earn an adequate return above their cost of equity whilst paying attractive dividends in this current attritional environment, yet possess the rate sensitivity to drive significant share-price appreciation should European interest rates normalise.
Mark Whitehead is manager of Securities Trust of Scotland. The views expressed above are his own and should not be taken as investment advice.