Banks Elevated Sovereign Funding Costs and European Banks

Elevated sovereign funding risks pose multiple threats to European bank stocks and we downgrade our sector view back to a “cautious” vs. index (as well as downgrade ratings on SAN, BBVA, Piraeus and EFG). We see five key risks: (i) funding costs materially higher, particularly in Southern Europe, hurting NII, while lower-for-longer rates postpone improvements in liability spreads. We estimate €3.3tn in total wholesale funding, of which ~48% could roll over 2010-12; (ii) loan growth to be challenged; (iii) provisions likely to rise from tighter conditions and some MTM losses; (iv) higher tax rates likely; and (v) higher costs of equity. We also see the risk of regime change from “managed deleveraging” to “accelerated deleveraging” with risks to bank stocks, credit markets and economies.

What’s in the price. We think the market implies ~14.2% 2011 returns from bank stocks on an ~11.5% cost of equity vs. our bottom up base case returns of 8.7% in 10e, 13.3% in 11e and 16.2% in 12e. We run a harsher scenario analysis that see returns fall ~2.4% (or prima facie take ~23% off price targets). We also recently argued bank regulation could shave ~1.5% off
returns before modification. Given our view that elevated sovereign spreads are likely to persist, risk/reward skew and uncertainty, we expect investors will anchor on nearer years and in tandem with our European strategists we downgrade the banks sector to UW vs. the index and see better value in US and EM banks.

Recommendations: We’ve factored higher sovereign risk into our cost of equity & revised views on returns and NPLs for a large number of banks. We would switch out of BBVA and SAN (cut to EW) into our best ideas: CSG, GLE, BNP (upgraded to OW), Baer, SHB, BARC, KBC, ISP or SDR. Least preferred: DX, RI, CBK, SEB, DPB, Piraeus (cut to UW), BKT, BME & LSE.

FULL REPORT HERE

Economics Group MONTHLY OUTLOOK February 10, 2010

Sovereign Debt Concerns in Southern Europe

In response to market concerns over its indebtedness, the Greek government has proposed an ambitious fiscal adjustment plan over the next few years. In order to help stabilize the government’s debt-to-GDP ratio, however, nominal GDP growth in Greece needs to rebound. But the common currency that Greece shares with the other members of the euro area precludes strong export growth via real exchange rate depreciation, which will hamper its ability to achieve strong growth in nominal GDP. In our view, there is a significant probability that Greece will need financial support from the European Union (EU) and/or the IMF to help the government smooth out its fiscal adjustment. The fiscal situations in both Portugal and Spain are not as dire as they are in the Hellenic Republic, but these two countries may also need financial support if investors remain spooked.

Growth Is Not Nearly as Strong Beneath the Surface

Expectations for near-term growth have been ratcheted up, following the fourth quarter’s robust 5.7 percent real GDP growth. While that number came in almost precisely in line with our forecast, we have raised our estimate for first quarter growth and slightly reduced our expectations for growth during the second and third quarters. The adjustments were necessary because inventories are correcting much more quickly than originally thought. Inventories added 3.4 percentage points to fourth quarter GDP growth and are expected to add another 1.2 percentage points to growth during the first quarter.


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