Last year I wrote a piece entitled ‘A Moment in the Sun’ in which I donned my rose-tinted spectacles and looked forward to a glorious new age of banking profitability and stability.
Clearly, war in Europe wasn’t part of the investment case. The inflationary pressures wrought by supply chain problems post Covid19 are still here. Semiconductors are still in very short supply, exacerbated even further by the fact that Russia is a major supplier of both palladium and neon, both important elements in the manufacturing process. But this is just one example. The sanctions put on Russia will increase inflationary pressure more widely. Already we are seeing oil and gas prices breaking to new multi decade highs, and food is likely to be in shorter supply as Ukraine’s harvest will be significantly impacted.
These large increases in energy prices are being felt by the consumer in the UK. Capped prices are rising by almost £700 p.a., or more than 50%, and this money will have to be found from reduced spending elsewhere. Energy prices feed through into all parts of the economy and act almost as a tax, reducing demand.
It seems plausible that this slowdown in economic activity will stay the hand of central banks in Europe and slow or postpone the rises in interest rates that we had been expecting. It also seems likely that a slowdown will lead to a greater number of business failures and personal debt defaults. These twin effects both impact negatively on the banking system’s profitability. Lower rates mean more pressure on interest margins, and bad debts come straight off the bottom line.
But how bad is it? The equity market has taken fright. From its peak on the 10th Feb, not even one month ago, the bank sector has retraced more than 30% despite delivering a very robust results season with higher than expected profits and capital returns announced.
It is this latter point, capital returns, that has frightened the horses I believe. Banks aren’t generally viewed as glamorous growth stocks. Quite the opposite. Post regulatory tightening since the Global Financial Crisis, they have become almost utility-like. That’s not a bad thing, mind you. Better that than the thinly capitalized and opaque entities of the early 2000s. But the expectation of investors is that the payback should come in strong and dependable dividend flows. That’s what was announced with the full year results this time around. Dividend announcements were high, with payout ratios in many cases in excess of 50% of profits, and the excess capital that had been accumulated over the pandemic period was assigned to share buybacks. It wasn’t uncommon to see a total yield (dividend plus buyback) in excess of 10% of the market cap of the bank in question.
Why the huge equity sell off? I have explained the potential slowdown in profitability above which reduces the quantum of dividend available. But also there is the memory from two years ago that in uncertain times (last time it was Covid19) the propensity of the regulator to give permission for payouts is reduced. Now, I’m not saying that I expect another dividend ban, but I would expect to see a rather more muted support for large buybacks, with the emphasis on retaining super-resilient balance sheet strength.
It is that very balance sheet strength that increases the attractiveness of bank credit, AT1 in particular. AT1 has sold off too, but not to the same extent as equities. Nevertheless, as many of the bonds are now quite short dated, at least to their call dates, relatively small price movements can lead to quite large movements in yield. There is now a raft of bonds with call dates 2-3 years away with yields to those calls of between 8% and 10%. That might mean the market believes the bonds will not be called. My belief is that the bonds have been pushed down by heavy selling pressure as parts of the market deleverage. These yields are as high as the yields we saw when AT1 was initially introduced in 2013, at the time of the European Sovereign Crisis, when banks were issuing to bolster their capital ratios. There was genuine fear at the time of sovereign defaults and the breakup of the Euro zone. The system is stronger today, far stronger. CET1 ratios, the fundamental measure of balance sheet strength, are commonly above 15%. Back in 2013, the comparable number was 11.3%, and let’s not forget that at the time the GFC kicked off, the figure was 5.9%, and that figure was measured in a more lenient way too.
So, while it is fair to say that the market abhors uncertainty, and we have plenty of that, it is also fair to say that every now and then opportunities arise, driven by unusual circumstances and sometimes forced sellers. It is the role of the active manager to capitalize upon these opportunities.