European investors mulling financials again

The financial-services sector, which includes companies like stock exchange operator Deutsche Boerse, private-equity investor Eurazeo and real-estate group Land Securities, dropped 3% in August. US homebuyers defaulting on their mortgage payments have led to losses for financial institutions exposed to these loans, including German lenders IKB and Sachsen, and have led to expectations of diminishing profits from underwriting at more solvent banks. Shares in French bank BNP Paribas, which sparked a worldwide stock-market downturn when it froze three funds that invested in asset-backed securities, fell by around 6% in August and shares in Germany’s Commerzbank, which has disclosed €1.2 billion ($1.63 billion) of US subprime holdings, have traded 5% lower.

The European Central Bank has been sending out mixed messages ahead of its interest rate setting meeting Thursday. At the same time as the bank is pumping liquidity into the market, ECB President Jean-Claude Trichet has also used the phrase “strong vigilance” - a term which has traditionally signaled an imminent rate hike - at least twice recently. Lorenzo Bini Smaghi, an ECB board member, said markets have “perfectly understood” comments from Trichet - and markets are divided on whether the ECB is going to hike or not. With that in mind, some are looking to pounce. “We are looking at buying interest-rate sensitive financials and property companies which should all do well in a falling interest rate environment,” said Oliver Russ, a European income fund manager at Argonaut Capital Partners in London.

Strategists believe that if the ECB keeps rates on hold at its next meeting, rather than raising again, then investors could become more positive on the financial sector. “Interest rates sensitive stocks would benefit if European rates stay on hold,” said Philip Shaw, a strategist at Investec Securities. “Higher interest rates tend to depress spending and borrowing, so banks tend to do less well in rising interest rate environments,” he added. Andrew Lynch, a European fund manager at Schroder Investment Management, who is overweight European financials including Italian bank Unicredit, agreed that a decision to at least pause by the ECB would be positive for financials. “If rate rises don’t come through then the choke-off to the economy won’t happen. Then there will be less risk of bad debt, and it will be easier for banks to fund their balance sheets if they have to take conduits on,” he said. Conduits are off-balance sheet investments, which sell short-term commercial paper and reinvest in higher-yielding debt. These investments have struggled as the commercial paper market has struggled.

Not for the faint of heart

Other fund managers were careful to note that European interest rates are just one driver for the European financial sector and that there are others factors that also need to be considered. A decision by the ECB to keep rates on hold “would definitely take away one of the negatives towards the sector but there are more important issues such as the US housing market and the commercial paper market,” said Mark Lovett, chief investment officer for UK and European equities at RCM, part of German insurance giant Allianz.

It is the US housing market and credit market woes that the Federal Reserve is currently attempting to address, with most economists now believing that the Federal Reserve will step in with a rate cut to alleviate current woes. If the Federal Reserve cuts interest rates then equity markets in general are expected to perform well. “Overall we would see Fed cuts as positive for global equity markets. Valuations do not look particularly stretched,” said Citigroup global equity strategists. These strategists put out a recommendation on Friday that investors buy financials outside the US.

Both BNP Paribas and Commerzbank are on the list, joining other firms such as HBOS, ING Group and Swiss Re. “They may have been the companies that got us into this mess in the first place but they also have the most to gain from the remedy,” they said. Citigroup said that its list of 20 financials that operate outside the US that offer “decent earnings and reasonable valuations” is not for the faint-hearted. (marketwatch.com)