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Don't write off these bank stocks

Concerns about asset quality, flattening yield curves, and tightening liquidity have meant a weak start to the year for financials - including banks and insurers. However, we believe the concerns are generally overdone given low valuations, manageable exposure to the energy sector, adequate capital positions and continued central bank liquidity provision in case of emergency. In this context, we think investors should maintain a preference for stocks in the European financial sector. On U.S. financials, we remain neutral.

The sudden concerns about global financials that erupted in February have caught markets by surprise. The MSCI Europe Financials equity index is down by 20.2 percent year-to-date, and U.S. financials have fallen 12.8 percent in 2016.


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The cost of insuring European subordinated bank debt via credit default swaps was 2.68 percent this week. At one stage, this figure breached 3 percent, the highest level since March 2013.

Behind the rout appear to be three main concerns.

First, asset quality may be deteriorating, particularly given the weakness in oil and commodity prices, and signs of a slowdown in economic growth.

Second, the yield curve is flattening. The difference between three-month deposit rates and 10-year lending rates in the U.S. is now at its lowest level since August 2012, and approaching early 2015 lows in the Eurozone, indicating future pressure on bank net interest margins. This could grow more problematic if central banks cut interest rates into negative territory and commercial banks are unable to pass these through to consumers.

Third, credit conditions are tightening, raising the risk of a self-perpetuating spiral of tighter credit conditions, problems refinancing debt, and consequent difficulties for seemingly sound banks.

However, we believe the current stresses are overdone.

First, exposure to the energy sector is manageable (commodity loans are 5 percent of total loan exposure for European banks) and, unlike in the sub-prime crisis, the debt is generally not repackaged and/or re-leveraged. Even in a stress scenario of 50 percent of sub-investment grade commodity-related loans becoming non-performing, the capital impact for European banks should prove manageable. Furthermore, there is presently no clear evidence that the global economy is headed for recession. We forecast real GDP growth this year of 1.6 percent for the Eurozone and 1.5 percent for the U.S.

Second, Eurozone banks have improved capital ratios since the sovereign debt crisis, so any deterioration in asset quality should have less of an impact than in the past. The average capital ratio among the major listed European banks rose to 12.6 percent in the first half of last year from 9.7 percent in 2008, and the vast majority of European banks have already reached 2019 capital requirement targets.

Third, valuations are already discounting weak profitability in any case. European bank shares are priced at 0.6 times the value of their net tangible assets, comparable to 2008-12 valuations. In the U.S., large multinational banks are trading at a 33 percent discount to the S&P 500, or below 10 times their estimated earnings over the next 12 months.

Fourth, central bank emergency provisions are still available. Banks in urgent need can exchange collateral for liquidity through the funding windows of the U.S. Federal Reserve and European Central Bank.

Of course, banks are still inherently leveraged businesses, reliant on external confidence and funding. Investors will need to prepare for near-term volatility, and remain selective in their approach to investing in financial capital and equity. But we believe the system as a whole is not at significant risk.

Within equities, we remain overweight European financials and neutral the U.S., where we favor large multi-national banks over diversified financials and insurance companies. Within investment grade credit, we favor senior unsecured bonds for banks with the most stable credit profiles. U.S. senior unsecured bonds remain less challenged relative to their European peers, as the largest U.S. banks benefit from a more unified regulatory environment and from having met fully phased in capital, liquidity, and leverage requirements.


Commentary by Kiran Ganesh, head of investment advice solutions in the Chief Investment Office at UBS Wealth Management, which oversees the investment strategy for $2 trillion in assets.

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