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European banking stocks are ready for a rebound, Barclays strategists say

Key Points
  • European banks suffered a sharp sell-off in the second quarter of 2019, shedding more than 13% over the past three months, and are down 18.64% over the past year.
  • Combined with depressed valuations and current bearish positioning from investors, the stabilizing macro environment could lead to further "short-covering," the buying in of securities that have been sold short (when traders bet they will lose value) in the hope of minimizing losses if the share price increases.

European banks are finally showing signs of recovery and investors should be looking to reduce their bearish positioning in the beleaguered sector, according to Barclays strategists.

In a note published Wednesday, Barclays' European banking and European equity teams projected that the stabilization of euro zone economic data and bond yields may bolster the banks, which have the most positive correlation to these two metrics of all European sectors.

"Euro zone composite PMI (purchasing managers' index) is stabilizing and the key domestic drivers of activity are well oriented," the note stated.

It added that in the meantime, bond yields and inflation expectations are "trying to find a floor," which gives a breather to value stocks, those which trade at a lower price relative to their fundamentals.

On top of this, the Italian government is "showing some fiscal discipline" and the European Central Bank (ECB) has opened the door to new quantitative easing while "seeking to mitigate the drag from negative rates on banks."

European banks suffered a sharp sell-off in the second quarter of 2019, shedding more than 13% over the past three months, and are down 18.64% over the past year.

However, they have begun to rebound slightly in recent weeks, gaining 5% over the past 30 days, and though consensus has the European banking sector at an underweight position, Barclays is maintaining an equal weight.

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European banks are not out of the woods, says strategist

Short-covering expectations

The Barclays strategists, led by head of European equity strategy Emmanuel Cau, also highlighted that bank stocks at present are cheap and under-owned. As the third-worst performing sector year-to-date, many banks are trading at a "near-extreme valuation discount and offer and attractive dividend yield of 6%," the note said.

Combined with depressed valuations and current bearish positioning from investors, this environment could lead to further "short-covering," the buying in of securities that have been sold short (when traders bet they will lose value) in the hope of minimizing losses if the share price increases.

The note highlighted, however, that "structural headwinds are not going away," with earnings remaining constrained by negative interest rate policy, and trade tensions, Brexit and anti-money laundering issues continuing to cloud the outlook.

But the analysts identified several banks which offer "quality at a reasonable price," and have established overweight positions in Lloyds, Caixabank and ABN while remaining "skeptical of certain restructuring stories" involving Deutsche Bank, Standard Chartered, UBS and BNP Paribas.

The note suggested Deutsche would struggle to achieve the revenue it sought from a recent mass strategic overhaul, and questioned whether the German lender might need to raise equity within the next 12-24 months.

"In our view, many investors simply believe the sector is not investible anymore and see it as a value trap," the note stated.

"While we agree that its medium-term profitability backdrop remains challenging, we think the some of the macro headwinds that exacerbated its recent underperformance are easing."