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Why a selloff in European banks is ominous

European banks have been caught in a perfect storm of market turmoil, lately.

Lackluster profits and negative interest rates, have prompted investors to dump shares in the sector that was touted as one of the best investment ideas just a few months ago.

The region’s banking gauge, the Stoxx Europe 600 Banks Index FX7, -5.59% has logged six straight weeks of declines, its longest weekly losing stretch since 2008, when banks booked 10 weeks of losses, beginning in May, according to FactSet data.

“The current environment for European banks is very, very bad. Over a full business cycle, I think it’s very questionable whether banks on average are able to cover their cost of equity. And as a result that makes it an unattractive investment for long-term investors,” warned Peter Garnry, head of equity strategy at Saxo Bank.

The doom-and-gloom outlook for banks comes as the stock market has had an ominous start to the year.

East or west, investors ran for the exit in a market marred by panic over tumbling oil prices CLH6, -3.95% and signs of sluggishness in China. But for Europe’s banking sector, the new year has started even worse, sending the bank index down 23% year-to-date, compared with 13% for the broader Stoxx Europe 600 index SXXP, -3.54%

So what happened? At the end of last year, banks were singled out as one of the most popular sectors for 2016 because of expected benefits from higher bond yields, rising inflation expectations and improved economic growth. That outlook, however, was before the one-two punch of plunging oil and a slowdown in China sapped investor confidence world-wide.

Garnry said the slump in bank shares is “a little bit odd” given the recent growth in the European economy and aggressive easing from the European Central Bank. Normally, banks benefit from measures such as quantitative easing, but it’s just not doing the trick in Europe.

“And its worrisome, because banks are much more important for the credit mechanism in the economy here in Europe than it is in the U.S. There, you have a capital market where it’s easier to issue corporate bonds and get funding outside the commercial banking system. We don’t have that to the same extent in Europe, and therefore [the current weakness] is a little bit scary,” he said.

Some of the sector’s collective underperformance comes down to exceptionally bad performances for a number of the bigger banks. Deutsche Bank AG DBK, -10.25% DB, -9.03% for example, has tumbled 36% year to date, amid a painful restructuring. And Credit Suisse AG CSGN, -5.02% CS, -4.37% is down 34% for the year as it posted a massive fourth-quarter loss.

But there is more to the sector slump than just the individual bank problems, according to Garnry. The negative interest rates set by the ECB means that banks effectively have to pay to have cash on their balance sheets, while at the same time getting squeezed on their net interest margins. Debt levels are already really high on the continent, which means further loan growth is expected to be low, he said.

And then there is the impact from a slowdown in growth.

“You have regulatory rules coming into play that is curbing and cutting back on the profits you can make in your capital markets division. You have general lower economic activity, which is also leading to lower activity in your advisory and M&A business. So it’s not very fun to be a European bank at the moment at all,” he said.

Saxo Bank was negative on the European banking sector going into 2016 and is sticking to the downbeat assessment longer-term. However, after getting clobbered at the beginning of the year, Garnry said short-term opportunities have emerged.

“Right now we have put on a tactical opportunistic trade here, where we have gone long European autos and banks […], because we believe the declines have been too sharp. We think there’ll be a reversal now coming into banks,” he said.

A UBS analyst is recommending a similarly opportunistic strategy for U.S. banks BKX, -4.13% , which also have been facing withering losses this year (albeit not as severe as their European counterparts).

( Source )

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