European banks: Climbing a wall of worry

Investor sentiment continues to strengthen, and nowhere is that more evident than in Europe — the new darling of mutual and hedge fund managers. The past 15 weeks have seen more than $22 billion pour into European equity markets, in the longest stretch of uninterrupted inflows since 2002.

The primary motivation would appear to be a shift toward favoring value over quality, as the broad Euro Stoxx 50 Index is 32% cheaper than the MSCI World Index of developed-market equities, based on the assets held by the companies. Also, while economic growth is hardly anything to celebrate (Spain posted its first quarterly GDP growth in two years, but it was a paltry 0.1%, and unemployment is still rampant), the trend is up, and some measures are pointing to a recovery. For example, the Markit Eurozone Manufacturing PMI rose to 50.3 in July, the first reading over 50 since 2011, indicating growth.

In the hunt for value, European banks offer the greatest discount to historical valuations. The Euro Stoxx Bank Index is still 70% below its pre-crisis level compared with the 20% lost in the broader index (Chart 1). In the US, financials are down around 44%, while the general market is now up over 11% since the crisis began.

While there is much work to be done to return Europe’s banks to health, a more proactive central bank and upcoming regulatory harmonization should help weed out the weaker banks and create a more robust banking sector.

Mario Draghi, the head of the European Central Bank, last week unveiled the bank’s plans for the third round of “stress-testing.” The Asset Quality Review (AQR) is to begin in November this year, and will conclude in 12 months. This means that there is a one-year window in which European banks may be insulated from severe headline-driven volatility, as the market awaits the AQR’s verdict on the health of banks.

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