The worst performing stock market sector by far this year is the financial sector, specifically banks. There are a number of reasons why banks have underperformed the wider market during 2016. Macroeconomic concerns, an increasing regulatory burden and falling returns are three of the factors that are weighing on investor sentiment, but the most pressing issue by far weighing on that sentiment is the interest rate environment.
Under threat
As interest rates continue to grind lower, the entire banking model is under threat. You see, banks’ profitability is linked to interest rates or more accurately, the interest rate spread. The interest rate spread is the difference between the interest rate paid to depositors and charged to lenders. Typically, when interest rates are rising banks can earn a higher return by hiking the rate charged to borrowers while delaying any increases in interest paid to depositors. In today’s world, this traditional model is almost impossible to operate. Lenders are competing for customers by slashing rates charged on loans, eating into the interest rate spread and profitability. What’s more, some central banks around the world have introduced negative interest rates, implying that there’s now a very real chance the interest rate spread could contract to uneconomic levels.
It’s also fairly common for banks to invest customer deposits in government bonds, enabling the bank to achieve a higher return on capital for minimal effort. But once again, as the yields on government bonds around the world plunge, it’s becoming harder to eke out a profit from this strategy.
All in all, the banking sector is facing a very hostile operating environment and while many European bank shares may now be trading for less than book value, unless there’s a sudden improvement in the operating environment, these banks could be value traps.
Value traps and better bets
The definition of a value trap is a stock that looks cheap after a recent dramatic fall in price but is actually still expensive compared to intrinsic value. If you take any of the major European banks, their shares look cheap compared to historic multiples. However, the question investors need to answer is whether or not the shares still look cheap in today’s hostile operating environment with interest rates at record lows?
Trying to determine whether or not a stock is a value trap is a tricky process, and it could be a better strategy to avoid the financial sector altogether. Indeed, there are a vast number of companies outside the financial sector that look undervalued and have a brighter outlook for growth.
Take the property sector for example. Since Brexit, UK REITs have taken a pounding over concerns about the commercial property market. Some of these companies now trade at a 20% or more discount to net asset value, which seems undeserved. Retail stocks have also taken a pounding, despite relatively upbeat consumer sentiment, and many small-caps are now trading at rock bottom valuations that more than makeup for any uncertainty ahead.
