European financials have weighed on investor sentiment in the region as a weak economic environment and geopolitical risks have adversely affected the sector.
The region's banking industry is closely tracked by iShares MSCI Europe Financials (NASDAQ:EUFN), most heavily weighted by HSBC Holdings (NYSE:HSBC), Banco Santander (NYSE:SAN), Allianz (OTCQX:ALIZF), Lloyds Banking Group (NYSE:LYG), and BNP Paribas (OTCQX:BNPQY).
The euro area has been plagued recently by falling inflation and manufacturing production, leading some market observers to fear deflation. Inflation unexpectedly slowed in July to 0.4%, compared with 0.5% in June, the weakest pace in almost five years. The Frankfurt-based European Central Bank unleashed an unprecedented round of easing measures earlier this year in order to combat the deflationary cycle.
For the past 10 months the inflation rate has been below 1%, less than half the ECB's goal, while joblessness has remained stubbornly near an all-time high for months. Meanwhile, a batch of Purchasing Managers' Index readings showed euro area manufacturing activity fell back slightly in July. The final number came in at 51.8, matching June's reading but below an earlier flash estimate of 51.9. The longer term trend shows that the index has steadily declined throughout 2014, leading to concerns over the health of the region's economic activity.
Also affecting the European financials is the shaken confidence due to Portugal's Banco Espirito Santo's (OTCPK:BKESY) stock plunging 67% over the past month. The Bank of Portugal ordered Banco Espirito to raise capital following a 3.6 billion-euro ($4.8 billion) first-half net loss. Portugal's central bank required the lender to raise the money after it set aside 4.25 billion euros in the first half, mostly to cover souring loans to other members of the Espirito Santo Group (OTC:ESFOF). The money set aside for loans cut Banco Espirito Santo's common equity Tier 1 ratio to 5%, less than the 7% regulatory minimum, according to a statement yesterday
The weakness of one of Portugal's largest lenders bodes negatively for all financial institutions in Europe as fears that the economy has not fully recovered from the Greek crisis spread. Although contagion is less of a threat now, bank stocks in the region have taken a hit.
Lastly, European financials have seen a knock in confidence as tougher sanctions against Russia could hurt the euro area's investments in Russia. Energy companies led markets lower, after the United States and European Union agreed to expand restrictions against Moscow, targeting Russian energy, defense and finance sectors. The tougher sanctions could adversely affect energy trade between Russia and Europe, thus creating uncertainty in bank-backed investments in the region.
Further sanctions "could have a material adverse impact on our relationship with and investment in Rosneft, our business and strategic objectives in Russia and our financial position and results of operations," according to comments made by BP PLC (NYSE:BP) regarding the conflict between Russia and Ukraine. European energy companies Royal Dutch Shell (OTCPK:RYDBF) and BP fell this week on the news.
The culmination of negative factors influencing European financials could lead to long-term destabilization. Economic weakness could potentially lead to deflation, which would hurt bank profits on interest baring investments. Similarly, profits could be harmed if Russian sanctions lead to loss of principle on investments made in the region by European corporations. Finally, the weakness in Banco Espirito has led to an outflow of funds from European financials, and could continue to weigh on company share prices as long as fear of bank failures are seen as possible.
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