The Sea! The Sea!

The Days Ahead:

• Consumer confidence surveys; Personal Consumption Expenditure (PCE) inflation

This Week:

• European banks are cheap
• But for good reason
• A giant report on European competitiveness hit the markets last week
• The outlook is not great
• The Federal Reserve finally cut by 0.5%
• We’ve been at the peak for 420 days and 1,648 days since the last cut
• There may be another 0.5% cut by year end
• The economy is holding up well

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The Problems With European Banks.

European banks are cheap. Many of the continent’s leading banks trade at around four to seven times earnings but they’ve struggled to attract much investment interest. We looked at the 10 largest European banks in the European stock markets and compared them to some U.S. counterparts.

JP Morgan, the U.S.’s largest bank is worth more the top 10 European banks combined. Investors value JP Morgan, Wells Fargo and Bank of America at $1,059 billion, or 50% above Europe’s top 10 banks at $705 billion.

What’s going on? We looked at the basic ways to value banks. How much does it earn on equity and assets, how many bad loans does it have and what is it paying shareholders? This is what we came up with.

The two banking industries are about the same size in assets at around $13,000 billion. But the similarities end quickly.

The top 10 U.S. banks are worth twice their European counterparts and they earn 30% more on an 11% larger asset base. That tells us U.S. bank margins must be higher.

We also looked at loan losses and U.S. banks have 18% lower loan losses. The actual numbers, at 0.70% and 0.85% may not sound large but banks carry very large assets. The U.S. banks have loan loss provisions of $92 billion or 76% of net income while European banks have $105 billion or 116% of net income. That tells us U.S. banks do a better job ensuring borrowers pay back their loans.

U.S. banks pay less to their shareholders with an average 3.8% yield against European banks’ yield of 7.3%. A high dividend yield is fine, but European banks are not retaining enough capital, preferring to pay it out to shareholders.

Finally, U.S. banks’ return on equity is 10.1% compared to European banks at 12.5%. That tells us European banks are either very good at squeezing out returns on their equity base, or they’re not sufficiently capitalized. A quick look at the net debt to total capital ratios shows 56% for U.S. banks and 81% for European banks. As any accountant will tell you, higher borrowings lead to higher, but riskier, returns on equity.

And that is exactly what European banks are doing. They have less capital, more losses, and lower margins but higher yields and returns on equity. Put all that together and investors clearly don’t like the risk tradeoffs and place a 37% discount on European banks, with U.S. banks trading at 11 times earnings compared to European banks at seven times.

It didn’t used to be this way. Thirty years ago, European banks carried higher multiples than U.S. banks.

Apologies for the crowded lines but we’re looking at the price to earnings valuations of key French, German and Italian banks. From 1994 to 2006, the average multiple for European banks was between 13 to 22 times earnings, while JP Morgan was 11 times earnings. From 2006 to 2024, the average multiple for European banks fell to 8 times and JP Morgan rose to 12 times.

What went wrong?

1. The Great Financial Crisis (GFC). European banks never fully recovered from the GFC. Not only were they encumbered with large loan losses and dodgy mortgages, but they never benefited from the equivalent of the U.S.’s Troubled Asset Relief Program (TARP) in 2009. This allowed the Fed to buy mortgages at face value so that banks would not have to write the losses against capital. The U.S. program committed to buying $700 billion of illiquid assets and selling them slowly as markets recovered. The total cost to the U.S. Treasury was only $31 billion as of 2023 and gave breathing room for banks to recover.

European banks had to wait until late 2010 to access a similar program called the European Financial Stability Facility (EFSF) but it was managed on a country rather than bank level. This slowed the recovery and sent European bank earnings into steep losses for years. Eight of the 10 largest European banks have yet to return to the peak earnings they made of 2007.

2. Fragmented bank system. The European Union (EU) has 4,500 banks with $32,000 billion in assets averaging $7 billion per bank. The U.S. is about the same with 4,036 banks (excluding credit unions) and $23,000 billion in assets for an average of $5.5 billion per bank. But the U.S. operates under a centralized banking regulator whereas the EU often prohibits mergers across borders and often confines lending activity to its home county. Many countries also lack access to equity capital, mainly because their stock markets are too small to absorb higher capital raises. The result is banks operate with insufficient capital.

3. “Do this or it’s slow agony.” Former Italian Prime Minister and ECB President Mario Draghi, issued a report last week calling for a united EU economic, energy and financial response to keep competitive against the U.S. and China. He singled out competition policy, industry consolidation, joint defense procurement programs and new trade agendas. He also addressed the banking system, recommending higher solvency, more securitization, and less variable rate, short-term loan financing. EU bank assets to GDP are at 350%, compared to around 90% for the U.S. In other words, European companies are entirely dependent on banks. He also called for a complete banking union so that European banks fall under a single set of regulations and deposit insurance.

Do this, or it’s slow agony” he said. Without major reforms, lack of growth, productivity and investment would continue along with low banking profitability. In a very accurate summary, he describes European banking woes.

“Banks are typically ill-equipped to finance innovative companies: they lack the expertise to screen and monitor them and have difficulties valuing their (largely intangible) collateral, especially compared to angel financiers, venture capitalists and private equity providers. [They] also suffer from lower profitability than their US counterparts… and lack scale relative to their US counterparts owing to the incomplete Banking Union.

EU banks also face some specific regulatory hurdles which constrain their capacity to lend [and]. It cannot rely on securitization to the same extent as their US counterparts. Annual issuance of securitisations in the EU stood at just 0.3% of GDP in 2022, while for the US the figure was 4%. Securitisation makes banks’ balance sheets more flexible by allowing them to transfer some risk to investors, release capital and unlock additional lending”

The high cost of operating a bank in the EU means average net interest margins (the amount a bank earns on a loan less the amount it pays for deposits) are around 1.6% compared to 2.8% to 3.3% for U.S. banks.

Last week, we saw Italy’s UniCredit Bank, valued at $60 billion, take a stake in Germany’s $21 billion Commerzbank, one of Germany’s powerhouse banks in the post-war period and valued at $400 billion in 2001. This sounds like a great move but the process was a mess. The German government announced it was  divesting a block of shares, asked for bids at €12.48 per share and watched helplessly as UniCredit offered €13.20. The German unions called foul, a Commerzbank board member said they’d fight it and European Central Bank President Christine Lagarde said it was a great idea. The German government lost control of the process which was not a surprise.

This could be a landmark case of long needed consolidation of European banks. Or it could all fizzle out in acrimony. So far, it’s been a bit of a mess.

European banks look cheap and they account for 21% of European stock markets, compared to 12% in the U.S. But the bank system needs to unify and improve earnings and its capital base. Otherwise, we’re looking at another decade of miserable stock market performance.

“The Sea, the Sea”

In his autobiographical “Anabasis” written around 380 BCE, Xenophon describes leading 10,000 Spartan mercenaries out of Persia after their employer met an early fate. It took the exhausted army two years with constant harassment by Persian forces, to find a way out. Finally, they found the coast as Xenophon reports:

Heard the soldiers shouting out “The Sea! The Sea!” and passing the word down the column. They all began to run, rearguard and all, and when they got to the top of the hill, had tears in their eyes and embraced each other. There was a lot of noise and laughter and people laughing”

They still had another 140 pages to go in the book but the waiting and uncertainty were over and the end in sight.

Now we’re not suggesting that waiting for the Fed to cut is like wandering around in Persia with no ships and hostiles in every direction (they do get home though)….but it’s sure nice to have this period of peak rates over.

The Fed started raising rates in March 2022, stopped in July 2023 and cut them on Wednesday September 18, 2024. We went back to when the Fed started using a target federal funds rate in 1971 (before that it was the “effective” rate based on transactions) and found that this cycle of unchanged peak rates was the second longest on record

Here we show the number of months that the Fed kept rates at their peak. Most of the time it was between one to six months before the Fed started to cut.

This time was different.

The Fed raised rates 17 times from June 24, 2004, to June 29, 2006, from 1.00% to 5.25%. They then held rates at 5.25% until September 2007 for a total of 446 days. This time, the Fed raised rates 11 times from March 17, 2022, to July 27, 2023, from 0.25% to 5.50%. The total time at peak rates was 420 days. It’s been a long wait.

Why so long?

The Fed started late. Headline inflation rose steadily from 4% in early 2021 to 8% in March 2022 but the first raise only took place in March 2022. Inflation peaked at 9% in June 2022 but the Fed kept raising for another 12 months. Inflation has fallen steadily ever since and is now around 2.6% for both the headline and the Fed’s favored PCE inflation. The Fed started late and wanted to make sure it did not have to reverse course.

If the Fed only followed inflation, it may well have cut earlier. But the Fed also has a mandate to “promote maximum employment” and on that front the story has been very good. In the second half of 2022, new jobs averaged 324,000 a month. In 2023, they were still running at 251,000 and in the first five months of 2024 at 225,000. Only in the last three months has the average fallen to 116,000. Those numbers exclude the 818,000 downward revision to the size of the workforce announced last month.

We’ve seen impressive resilience in the workforce in the last few years but employment is beginning to cool and the Fed did not want to wait for something to break.

The Cut

On Wednesday, the Fed announced a 0.5% cut in the fed funds rate to 4.75% from 5.25%. This was more than the 0.25% expected two weeks ago but in line with the “leaked” number we heard last week.

Does the 0.5% cut mean the Fed is worried?

No. The Fed has cut by 0.5% five times since 2003. Once in mid-pandemic in 2020 and four times in 2007 and 2008 during the financial crisis. That would suggest some worry on the part of the Fed. But neither is a good guide.

In our thinking there are two types of cuts:

One, as in 1995, when the Fed just wants to avoid a recession. Unemployment and inflation were steady but indicators like manufacturing and housing starts were down.

Two, as in 2007 or 2020, when the Fed is cutting quickly to avoid catastrophe. In 2008, the unemployment rate rocketed from 5% to 9% in six months. In 2020, unemployment grew from 3% to 15% in two months.

We’re in the first camp. Growth, retail sales, and housing starts are down but not by too much. Inflation is heading down consistently and employment growth is slowing. The economy may not be as strong as it was a year ago but it’s managing quite well, thank you. The latest GDP forecasts is for a still healthy 2.9%.

So, it’s about time they cut. How did stocks do?

During the 2004 to 2007 raise cycle, the S&P 500 returned 40%. In the 446 days that rates stayed at their peak from 2006 to 2007, the S&P 500 rose 22%.

During the 2022 to 2023 raise cycle, the S&P 500 rose 33%. In the 420 days that rates stayed at their peak from 2023 to 2024, the S&P 500 rose 26%.

We’d note that the Fed let stocks run too hot in 2006 and 2007, as shown by the 48% collapse in the market from September 2007 to February 2009. This time stocks did better during the “at peak” stage than the 2006 peak period suggesting the Fed has managed this cycle well.

The Bottom Line

Much of the week’s news was about the Fed. The initial market reaction to Wednesday’s announcement was a quick rally.

Overnight buying in stocks took the S&P 500 up another 1.8% on Thursday to an all-time high. Stocks have risen nearly 20% this year. The track record on stock performance in the 13 periods after a rate cut is patchy over the short-term with the market up five times and down eight times. But push out the returns for a year and the market rose nine times, with an average return of 18%, and fell four times.

You’ll see statistics around the before/after rate cut events but we’d go back to the fundamentals: we have a slowing but not halting economy, lower inflation and a job market with 96% of the workforce in jobs.

For the first time in over two years, the yield curve is positive or not inverted, meaning long-term yields are higher than short-term yields. An inverted yield curve is a popular recession indicator but like many Wall Street rules of thumb, hasn’t worked this time.

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Art of the Week: Clark Voorhees (1871-1933)