Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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The value trade and European banks
Peter Garnry
Chief Investment Strategist
Summary: European banks have a considerable upside potential over the coming year if the mean reversion in the German 10-year yield continues amid rising global inflation. A steeper yield curve and positive yields in Europe could take European banks' price-to-book ratio back to the recent historical average of 0.8x and then beyond. The industry has improved over the past years with Deutsche Bank being put forth as an example of Europe's banking industry coming out of a long hibernation.
The value vs growth trade has been ongoing since November 8, when the world got the news about a highly effective mRNA vaccine against Covid-19. It reversed all trades and while the value vs growth trade has been a bumpy ride the direction seems to be in favour of value stocks. Helping the trend is the rising interest rates which directly lift valuations of financials that benefit from steeper yield curves and return on their loan books. The German 10-year yield has moved 44 bps. higher from the lows in December but has recently corrected a bit.
However, the inflationary pressures are not easing anytime soon with supply bottlenecks persisting for the rest of the year combined with extraordinary fiscal stimulus (see chart) and loose monetary and financial conditions. It all points towards an increased likelihood for sustained higher inflation in the world including Europe.
The last inflation cycle was from early 2016 to mid-2018 driven by a big impulse from China lifting the country’s producer prices and thereby exporting inflation to the world. During that period, the core CPI in Europe rose 60 bps. and headline CPI rose almost 200 bps., with European banks seeing their price-to-book ratio increase by 0.4 points driven by rising yields, steeper yield, and improving credit conditions. Deutsche Bank has many times been called the sick man of European finance, but the latest CEO Christian Sewing has reversed many fundamentals and the news flow on European finance is no longer outright negative.
Our view is that the value vs growth, higher inflation, and higher interest rates, will continue the mean reversion happening in the German 10-year yield and help European banks move back to the average price-to-book ratio since 2009 of 0.8x and likely beyond to 0.9x helped by macro policies. This means from current levels that European financials could see a 21-36% upside over the coming 6-12 months.
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