European banks' share prices have declined by 11% over the past year and 5% over the past three months, reflecting concerns first around banks with emerging market exposure and the impact on global trade of the escalating tariff war.
Banks with a strong global and emerging market presence have been under the most pressure. Populist policies from the Italian coalition government could be a risk, not only to Italian banks but also the whole eurozone. Danske Bank (DANSKE) and ING (INGA) have been punished severely by the market as regulators dished out heavy fines for failure on their part to pick up on money laundering.
Morningstar equity analysts prefer to look through the shorter-term cyclical issues that concern the market and focus on long-term secular drivers. Our main concern is the low medium term profitability we foresee for the European banks. Return on equity ratios in double digits have become the exception and the bulk of the banks in Europe will not generate returns ahead of their cost of capital consistently.
Prudential (PRU) is the second large European listed insurer going through significant corporate activity with the proposed divestment of its United Kingdom, European, and asset management operations.
We still think this plan for separation highlights a number of key trends occurring in the European life insurance space. First, the lines between life insurance savings and asset management have been substantially blurred with the rise of unit-linked products. Second, we see a bifurcation occurring within the market.
No Return to Pre-Crash Levels
Premium operators like Prudential rely on good quality advice to retain and attract policyholders, as well as reputation on service, payments, and investment returns. Whereas lower down the spectrum of individual wealth, scale is becoming the name of the game, attracting assets and focusing on retention through digital experience, service, guidance and advice, as well as the requisite reputation on service, payments, and investment returns.
We think Prudential is fairly valued, having dropped in value from £17.80 at time of initiation to just below our current fair value estimate of £16.90. The current share price is around £15.66. The rough timeline for this demerger is completion by end of 2019.
While we concede that banks and insurers' net interest margins stand to benefit from higher interest rates, we do caution that investors should not expect a return to margins as they were before the 2008 financial crisis, because most banks now have much lower risk appetite hence lower credit spreads have become the norm.
Loan loss provisions are close to all-time lows and they will increase going forward. The new accounting standard dealing with impairments of financial instruments, IFRS9, has yet to be tested during a downturn in the credit cycle, and it adds to the high level of uncertainty as to what constitutes a medium ter, level of impairments for European banks. Banks have been successful in driving down their cost/income ratios until now but the visibility of future efficiency gains are less clear to us.
