Euro zone banks rally falters on earnings outlook

LONDON (Reuters) - A big rally in euro zone bank shares on the back of central bank action to fix the region's debt crisis may have run its course as doubts over the sector's earnings outlook keep many long-term investors sidelined.

While stock markets have paused across the globe after a June-September rally, worries over regulation and the growth outlook may see euro zone banks underperform even if other stocks make further gains.

Euro zone banks are up over 40 percent <.sx7e> since European Central Bank President Mario Draghi pledged in late July to defend the euro, prompting many betting against banks most exposed to a collapse of the currency to close the trades.

But looming regulatory demands, including that banks hold more cash to protect against further financial stress, promise to suppress earnings growth for the foreseeable future and make what was once a very cheap sector seem relatively overpriced.

"A lot of the policy concern has receded... but we are at a point now in terms of valuation of the banking sector where we need to see the next stage in terms of growth... and earnings uplift in order to drive the sector forward," John Bilton, European Investment Strategist at BofA/Merrill Lynch, said.

Banks in peripheral Europe have been under the microscope since spiraling debt costs in countries such as Spain shut most out of debt and money markets and led governments to seek billions of euros in international aid.

While the threat of euro zone break-up and a renewed banking crisis has faded for, there has been no rush to buy bank shares.

"My concerns about bank stocks are that regulatory pressure combined with higher capital requirements will be a burden to profitability going forward," said Stefan Angele, Head of Investment Management at Swiss & Global Asset Management.

"Compared to some other sectors (like Healthcare or IT), the financial sector as a whole looks less attractive, especially after the recent rally that has brought valuations up again."

While the rally still leaves most banks trading below their "book" value - the accounting value of the firm's assets - which makes them underpriced by pre-crisis standards, valuations compared to recent history are less attractive.

Spain's Banco Santander , for example, trades with a price to book ratio of 0.8, meaning the stock is trading at a 20 percent discount to its accounting value, according to Thomson Reuters StarMine data. This is cheap compared to a 15-year average of 1.7, but is higher than the two-year average of 0.7.

Spain's banking crisis does not make this trend exceptional, and other euro zone lenders tell a similar story.

France's Credit Agricole , for example, is trading at a Price/Book of 0.36, below its 15-year average of 0.85, yet at a premium to the two-year average of 0.28.

In spite of the ECB action and the subsequent rally, for some, banks are still trading below book value for good reason.

"I don't own any, and I can't imagine hardly any scenario when I'd want them," Neil Dwane, Chief Investment Officer for Europe at Allianz Global Investors, said of euro zone banks.

"Many of these banks have not yet been honest about what's on their balance sheet and what it's worth."

With much of the euro zone in recession, many banks are burdened with non-performing loans on real estate and other toxic assets.

GO WITH THE FLOWS

Hedge funds led the way at the beginning of the banks rally, closing out short bets, but longer-term mutual funds show no immediate inclination to chase the market higher.

UBS equity strategist Karen Olney said hedge funds, "underweight" banks three months ago, were now "neutral".

However, a recent poll of fund managers by BofA-Merrill Lynch showed fund managers were still net underweight on euro zone banks, although by less than before Draghi's pledge.

HSBC strategist Peter Sullivan said the rally in euro zone banks could go further if mutual funds moved from "underweight" position to "neutral" in line with the recent gains.

"The big international funds start from a position way below benchmark. In a positive case for banks you get the equivalent of a short squeeze, where the sector starts to outperform, which hurts, so then they start to close the underweight," he said.

Sullivan said Spanish banks, which took a hit earlier in the year, could benefit from ECB bond buying before the end of 2012.

However, given the risks the euro zone banking sector faces, and the poor experience of recent years, some investors may be very wary before switching their flows back to euro zone banks.

"In an environment, when it's been right to take the pessimistic side whenever it comes to banks, it's not surprising that investors aren't immediately switching," he said.

(Reporting by Alistair Smout, additional reporting by Ingrid Melander, editing by Nigel Stephenson)

Source: http://news.yahoo.com/euro-zone-banks-rally-falters-earnings-outlook-132536968--business.html

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