Why are bank stocks so cheap?
Possible reasons include:
1. High probability of recession
2. Interest rates may fall back to 0%
3. Upcoming regulatory changes
4. Politicians’ tendency to tax banks if they make excessive profits
5. Investor preference for safer stocks
6. Risk of financial crisis
Taking each one in turn:
1. A recession would lower bank profits, but stress tests published by central banks show that banks are resilient against large declines in GDP.
2. Our view is that interest rates will stay higher this decade due to changing demographics, geopolitical fragmentation, commodity shortages, and the need for green energy investments.
3. Upcoming regulatory changes (Basel 3 final rules) are by now largely known and can be modelled. It is surprises that move share prices, not pre-announced changes.
4. Italy, Spain and Hungary all implemented new taxes on banks over the past year. But these taxes were not set at confiscatory levels. After a tax is announced, its impact can be modelled and shares bought with the tax hit already priced in.
5. A value investor has to buy shares that others do not want. There are few or no free lunches in the markets.
6. Of all explanations for the cheapness of banks, this is the most important. The risk of financial crisis is tied to how high interest rates need to go, so we would ideally like interest rates to stabilise at current levels and not increase. For example, while Italy’s debt is sustainable at current rates, it may not be so if interest rates increase to 5%.
Overall, we find risk-reward in (European) banks attractive, and so hold the majority of the portfolio in banks, despite the above-mentioned risks and the high volatility of the sector.