It is only fitting that on the morning in which Europe levied the largest cartel fine in history against the criminal syndicate known as "banks", that Goldman Sachs would issue its #6 "Top Trade Recommendation" for 2014 which just happens to be, wait for it, a "long position in large-cap bank indices in the US, Europe and Japan." Supposedly, in a reflexive back and forth that should make one's head spin, this also includes Goldman Sachs (unless they specifically excluded FDIC-insured hedge funds, which we don't think was the case). So is Goldman recommending... itself? Joking aside, this means Goldman is now dumping its bank exposure to muppets.
Top Trade Recommendation #6: Long DM (Japan, US and European) Banks
- Our sixth Top Trade recommendation for 2014 is a long position in large-cap bank indices in the US, Europe and Japan, implemented via equal parts of the BKX, SX7E and TPNBNK indices.
- We expect a significant pick-up in DM economic growth, stemming from domestic demand strength …
- … fading fiscal headwinds in the US and Europe…
- … and a continuation of accommodative policies by major central banks that will keep short-term rates anchored
- Banks valuations remain well below pre-crisis levels…
- … and steeper yield curves may help improve net interest margins
- Risks include growth disappointments, violent rate shifts as monetary accommodation is withdrawn, and a change of sentiment towards the banking sector
Top Trade Recommendation #6: Long DM (Japan, US and European) Banks
Our sixth Top Trade recommendation for 2014 is a long position in a basket of developed market banks: US banks (via the BKX index), European banks (via the SX7E index) and Japanese banks (via the TPNBNK index), in equal portions with an initial target of 20% and a stop at -10%. The opening price of 100 for the indexed basket will be marked on the US open on 4 December 2013.
The BKX index was one of our 2013 Top Trade recommendations as well. The trade was closed at the end of August of 2013, for potential gains of about 27%, as the broad summer risk-off move, driven in part by the US government shutdown and debt debate, drove the index below the trade’s stop loss, which had been raised multiple times throughout the course of the year. Although the US financial sector has not led the market higher since then, the fundamental case for banks, in our view, remains intact. The 2014 Top Trade recommendation is a more global implementation and leans on our 2014 macro views.
Two forces that supported the banking sector in the US in 2013 are also likely to be present more broadly in major DM economies (US, Europe and Japan) in 2014. The first is a significant pick-up in economic growth, which from a DM perspective, is mostly about domestic demand strength (along with fading fiscal headwinds in the US and Europe). The second is a continuation of accommodative policies by major central banks that will keep short-term rates anchored and maintain easy financial conditions, even if the forward outlook for incrementally more policy accommodation is different in the three regions.
DM equities more generally remain the most likely asset to benefit from this combination of forces, with the DM financial sectors still well discounted even after significant 2013 rallies.
DM growth acceleration and policy accommodation at the heart of this trade recommendation
Our headline theme for 2014 is 'Showtime for the DM recovery' as we foresee that DM economies will, for the first time since the financial crisis, reach, and perhaps even surpass in some places, trend growth. We expect the US economy to accelerate to about 3.0%-3.5% over the coming quarters, spurred primarily by a pick-up in consumer spending and business investment, along with fading fiscal headwinds. The case for Europe is a bit more muted, but there too we expect growth at around a 1% rate, which is moderate, but significantly above the 2013 run rate. And while Japanese growth is likely to remain stable, the DM-wide domestic impulse is likely to support portions of the economy that are particularly levered to consumer spending, including the housing market and the banking sector.
Along with better growth outcomes, we also expect yields to gradually climb. However, here the picture is a bit more nuanced, as some central banks will likely begin to exit from accommodative policies sooner than others. In the US, we expect that process to start with the 'tapering' of asset purchases in March of 2014. That said, the US move towards the exit will be combined with increased commitment (through forward guidance) to supportive policies. And while it is possible that these shifts will generate some yield volatility, we think violent shifts in short-term yields are unwarranted. Overall, we expect banks, particularly in the US, to benefit from steeper curves. And while a steepening curve may provide less of a tailwind for European banks, there are some likely benefits in bank regulatory harmonization and the potential lower cost of capital.
While more dramatic rate views are clearly a risk to our constructive equity views in general, longer-term yields are priced more or less in line with our macroeconomic expectations. Our base scenario calls for only moderately faster growth in 10-year yields relative to the short end of yield curves. This leaves the 'belly' of the curve – with maturities in the 5 to 7 year range – as the most exposed to further steepening forces.
Historically, the performance of banks (and to a lesser degree, banks’ outperformance relative to broader equity indices) is mildly positively correlated with the level of yields, both in the 5-year and the 10-year range, as well as with the steepening of the curves, with banks' fundamentals providing a likely linkage between the two. A steeper yield curve is likely to support banks’ net interest margin (NIM), a spread between the rate at which banks lend, normally a longer-term rate, and the rate they pay for the borrowed funds, normally a short-term rate.
Currently, NIMs in all three indices are at the lower end of their ranges over the last 10 years. In the US, the median NIM in the BKX index in 2013 is 3.2%, around 20bp below the 2012 level, as the steeping yield curve has so far failed to push it higher. Historically, the median NIM in the BKX has fluctuated in the 3%-4% range over the last 10 years. And in both Europe and Japan, median NIMs for our chosen bank indices are at the low ends of their 10-year ranges, around 1.5% in Europe and 1.3% in Japan. If we do see steeper yield curves in 2014, it is possible that some improvement in NIMs will follow.
Even after the 2013 rallies, banks trade at a discount
Alongside broader equity indices, bank indices in the US, Europe and Japan have all had strong years. Japanese banks are up almost 40% year-to-date (with much of that gain front-loaded, and a touch below the broader TOPIX index year-to-date). European banks struggled early in 2013, but have since recovered, and are now up around 20% on the year and ahead of the STOXX index by a couple of percentage points. And US banks have rallied about 26% year-to-date, and have outperformed the S&P 500 index by around 3% over the same period, as they gave away a considerably wider outperformance margin gained earlier this year.
Yet these rallies still leave the banks well below pre-crisis levels, and in the case of Europe, even below post-crisis 2010 highs. While shifting regulatory and structural backdrops suggest that 2007 levels are not likely to be attainable in the near term, the recent strong performance is modest when looked at in a longer perspective. And from a valuation perspective, while the 2013 rally has increased indices’ price-to-book ratios, but they remain near 10-year lows. In the US, the index is trading about 1.2x book, with Japan and Europe still trading below book at 0.7x and 0.8x respectively. Like price levels themselves, these ratios are well below pre-crisis values. To be fair, historical comparisons of current P/B ratios with the values over the past decade may be less relevant given regulatory changes and the prolonged presence of supportive fiscal policies and accommodative environments. Still, while a return to pre-crisis valuations seems unreasonable, it is reasonable to expect some improvement here too, as the overall risk-taking backdrop improves.
As this trade leans on some of the key components of our 2014 outlook – an improvement of growth in DM economies and a well-managed gradual withdrawal of some policy measures – the risk to the trade is that these views do not materialize. Specifically, we can identify three main risks.
First, domestic DM growth may disappoint. While this will affect the most pro-cyclical parts of the market the most, the banking sector will likely be affected by lower consumer spending, including weaker housing markets and weaker investment.
Second, rate moves may prove to be more dramatic and volatile, if the tools to manage the stimulus withdrawal prove insufficient. While we in general believe that possible overreactions to the stimulus withdrawal are unwarranted, some of the price shifts in 2013 proved that these episodes may be quite painful.
Third, even if the growth shows up and the stimulus withdrawal is well managed, the regulatory backdrop and sentiment in the banking sector in particular may turn more negative, driving this segment of the equity market lower relative to broader indices.