The current year has been positive for financial credit and equities from a fundamental but also a valuation perspective. At the start of the Covid crisis, there were concerns and significant provisioning against potential losses for the banking sector. There was also unprecedented regulatory and government support for the economy, which kept corporate default levels at manageable levels.
Banks were quite resilient, having come into the pandemic in a strong position from a capital and liquidity perspective. There were no defaults in the banking sector in Europe.
We came into this year following three years of substantial equity underperformance compared to financial credit. From 2018 to 2020 bank equity lost more than 37% in aggregate in Europe. This year has been a reversal, with bank equity outperforming financial credit and the wider market. This is a result of the removal of the dividend ban, improved economic growth data and the outlook for rising interest rates, which support more optimistic earnings outlook — a key driver for equity valuations.
Now we’re at a crossroads. The support measures for the economy are being removed and this leads to some concerns going into 2022. The inflation debate is becoming crucial. It appears that inflation will last longer than initially expected, into the first part of next year, especially in the US and UK. This will put pressure on central banks to act, and they will have to be careful not to harm the recovery, which is still incomplete, especially in Europe.
From a credit risk perspective, we’re less concerned about systemic volatility. Taking the lessons learned in 2020 — the regulatory playbook and how the crisis was dealt with — we think this would be deployed again in case of further stress.
On a valuation point of view, we remain cautious about the most senior part of bank credit. This is because the yields are quite low and not enough to counterbalance higher inflation and negative real yields. In addition, banks may have to issue more at the senior level next year.
In contingent capital, or CoCos, the yields are still attractive and well in excess of generic high-yield credit, with a with a much better risk profile. Also, the supply outlook is supportive to valuations given we will probably see negative net supply in 2022. Fundamentally, European banks have a strong capital position, well above the minimum requirements therefore should be able to absorb well even a potential deterioration in asset quality during the year.
We also see opportunities in credit of less well-known banks and financial corporates, where the bonds are not priced to perfection, like most global banks (G-SIBs), and they offer a substantial pick up when compared against generic high yield credit.