An econometric analysis of the sector’s historical excess returns reveals the following fundamental characteristics:
- Banking is a domestic – not a global – sector as back-testing underlines that its excess returns are positively correlated with economic growth expectations, inflation expectations, consumer confidence and long-term interest rates.
- Banking is a risk – not a defensive – sector as back-testing underlines that its excess returns are negatively correlated with equity and credit risks.
- Banking is a cheap sector, with low PE, low PBV and high dividend yield, and still trades at a relative valuation discount to its long-term average composite valuation; however, “cheap” does not systematically mean “value.”
During the peaks of the Covid pandemic, i.e., in a deflationary environment (recession and deflation), the sector sharply underperformed the benchmark (Delta P<0) due to both a valuation derating (delta PE<0) and a degradation of profit expectations (Delta E<0). The banking sector was a value trap.
However, the eurozone is the new growth story: economic surprises are strong and growth expectations, despite a recent slowdown, remain robust. It is interesting to note that growth expectations in the eurozone are now stronger than in the US and China.
Eurozone employment has benefited from this strong economic rebound and the unemployment rate has fallen back to pre-Covid levels at 6.4%, supporting consumer confidence.
Another positive effect is the significant fall in both credit risk and equity risk.
However, the strong economic growth, combined with ongoing Covid disruptions, triggered a series of supply chain disruptions, i.e., an acute disequilibrium between strong demand and limited supply, leading to a rebound in prices. The most striking examples are in the semiconductors, jobs, and oil markets.
Inflation thus rebounded to a 20-year high in January, well above expectations, creating a surprise inflation shock.
Moreover, our indicator of aggregate surprises, which this time includes both economic surprise and inflation surprise, reached a 20-year high, pushing the ECB to adopt a more hawkish tone and leading to a rebound in both the eurozone long-term yield and the euro.
As the environment becomes more reflationary (robust economic growth and strong inflation), the banking sector has outperformed the benchmark (Delta P>0) due to both a sharp valuation rerating (delta PE>0) and a strong improvement in profit expectations (Delta E>0). With the ECB turning more hawkish, the sector is becoming a true value story – rerating from zero to hero.