European banks may have failed to properly price in a possible recession combined with high inflation, known as ‘stagflation’, JP Morgan warned today.
This could lead to potential material earnings losses among banks that have not properly modelled for such a scenario, the investment bank said in an analyst note.
JPM analysts compared the current situation of market inflation being at multi-decade highs with the decade between 1970 and 1983, a critical period plagued by two global recessions.
Some important and even surprising lessons can be learned from the prolonged period of stagflation in the 1970s.
A recession-inflation environment is “better for banks than a traditional recession”, the investment bank said, which observed “ongoing revenue growth” among banks during the last long period of stagflation in the 1970s.
During this time banks demonstrated “positive operating leverage”, according to the bank’s analysis, meaning shoring up liquidity may be of greater importance than leverage concerns for banks right now.
“Banks are likely to materially underperform leading up to a recession but this reverses and banks are excellent buys when provisions peak,” JP Morgan analyst Kian Abouhossein said in the analyst note.
Banks underperformed the market by 21% at the height of the global recession in 1974 and 1975, “with rising provisions”, meaning they banked more loan losses on their balance sheets during that period.
However, from 1976 to 1978 the tides changed and they outperformed the market as these so-called “provisions” or losses on loans had peaked and been absorbed by the banks a couple of years before.
By the eighties, banks had learned a hard lesson.
Their price performance “improved” following the first recession, according to JP Morgan’s analysis of the global recession of 1974-75 and the next recession in the early eighties.
“In the subsequent recession, banks did not underperform to the same extent (-14%/0%) that they did in 1974-75 (-21%), as the market got a better understanding of the framework and therefore was likely better able to assess risks,” the bank’s analysts said.
JP Morgan predicted that a “fast and furious v-shaped crisis” would be the most likely future recession scenario, noting that four money-centred banks in the dollar market had US$45bn in reserves in the first half of 2020, according to IFRS 9 and CECL data.
The ideal portfolio for investors would marry the best risk-reward between a “soft-landing and stagflation scenario”, the bank said.
Its analysis suggests that banks such as Dutch bankING Group (NYSE:ING) ING Group (NYSE:ING), Austrian bank BAWAG, Irish lender AIB Group PLC (LSE:AIBG) and UBS Group AG (NYSE:UBS) may have modelled for stagflation better than others, according to analyst Kian Abouhossein.
According to analysts, the risk versus reward of German, French, Spanish and Italian bank exposure is “unattractive in [the] ‘core’ Euro area”, with ABN Amro and Nordic bank SEB Group potentially among those most at risk.
“As a sensitivity, every 10bps cost of risk is an average 7% of PBT [profit before tax] for European Banks,” Abouhossein said.
Analysts said that in the event of another recession, the number of banks taking a future loss on loans through provisions “would likely peak at higher levels" and "faster” than before, though since the interest rate shock in the nineties, investment banks are now leaner and have moved from being inventory heavy to being more execution-focused.
“In a global context, we prefer US banks valued at 7.3x P/E 2024, a 7% premium to Eurobanks vs. a historical c20% premium,” JP Morgan’s analysts said. “We do not agree with the view that a recession-inflation scenario is priced in, i.e. before provisions peak as we are likely to see material earnings cut in such a scenario... where Stress P/E is 12.7x 2024E vs. 6.8x in our current 2024E forecasts offering 30% potential downside.”