The research for this article began with a simple question: why are U.S. banks overperforming European banks?
The banking industry has suffered a paradigm shift. Once, there were thin capital requirements, positive interest rates, economic growth, and stability within the industry. Now, we have demanding central banks, near-zero interest rates, a European mess, a Chinese slowdown, and fintech startups.
All of the mentioned constraints are relatively equal on both sides of the Atlantic Ocean. Therefore, there is no immediate reason for such a wide difference in performance between European and U.S. banks. However, European banks haven't performed well since 2009. In the graph below, we can see that three of the biggest European banks, BNP Paribas (OTC:BNPZY), Deutsche Bank (NYSE:DB) and Banco Santander (NYSE:SAN), have underperformed the S&P 500 by a huge margin.
Graph 1 - BNP Paribas, Banco Santander, Deutsche Bank vs. S&P 500 (2009 to 2015)
Graph 2 - Wells Fargo, JPMorgan and BofA vs. S&P 500 (2009 to 2015)
These two different outcomes within the same industry but in two different geographies is very interesting. Since the reason is not significantly different regulatory contexts, then the reason for this must lie on the macro fundamentals of the U.S. economy versus the EU economy.
In this article, I'll explore the macro fundamentals of both the European and U.S. economies. I believe that the macro factors (on a broader sense) positively influence the microeconomics of the U.S. banks. I will explain in detail my reasoning.
A previous note is needed. In some sections of this research, I've developed theories and explanations that are not in accordance with some of the views accepted by the financial community. I hope the reader can take value from the alternative views.
Macro Fundamentals Of The U.S. Versus The EU
There are a couple of macro quantitative indicators that can illustrate the huge difference between the U.S. and the EU, but allow me to start by stating what I believe to be the main differentiating factor among these two blocs: reality perception. The present state of politics in the EU leans to the idea of free market, and for the EU policymakers, U.S. represents the pinnacle of free market.
However, I see this as a wrong assumption. The truth is European policymakers try to copycat what they perceive to be the U.S. free market ideology, whereas in reality, the U.S. does not apply a 100% market free approach to its politics (far from that).
One example is the international trade. The EU has been hugely receptive to international trade even when this move has been endangering some industries. I believe that part of this tendency stems from the fact that Europe is very dependent on energy imports, which has made European policymakers very keen of international trade.
Now, don't get me wrong, I believe that any country should have a leveled commercial balance. What my research has revealed is that there is some evidence that a heavy dependence on international trade might be the wrong path to pursue.
The Case Of The Goods And Services Market
U.S. has a higher degree of protectionism than the EU on significant national industries whereas the EU has allowed a market free approach that has destroyed several industries, especially, the periphery countries. This higher protectionism doesn't come solely from import barriers, it also comes from the public sentiment towards foreign products. The U.S. is well known to be a difficult market to enter. The result is that, according to WTO (World Trade Organization), the EU has a 33.9% trade-to-GDP ratio whereas the U.S. has 29.9% for the same indicator (2014 to 2012 average).
This indicator offers an interesting conclusion: the U.S. economy relies more on internal activities for its GDP than the EU. However, this effect can be even bigger if we account for the fact that in the previous figures the intra EU trade was excluded. I believe we should include the intra trade numbers. The explanation is simple; the EU members do not cooperate in trade, and in reality, they are fierce competitors in the EU market. This phenomenon is something that does not have a correspondence to the same extent in the U.S. reality. Let us now see how the trade figures compare when including the intra EU trade.
Table 1 - Trade to GDP for the EU (including intra EU trade) and the U.S.
We can theorize about what these numbers really mean. For instance, U.S.'s huge internal market is an incentive for stronger corporations, which ends up creating a self-enforcing cycle due to higher available income for individuals. On the other hand, EU's internal market functions as a fierce arena where everyone tries to dump their products while kicking the neighbor away from business. Although, there is competition within the U.S., I believe it to be significantly lower, which allows for a better distribution of economic activity and available income.
Table 2 - Household consumption to GDP for the EU and the U.S.
Europe on the other hand seems overexposed to international trade, which means competing in a fierce arena where demand is frequently defined by price. This means paying less to individual workers in order to contain costs, hence the lower household consumption rate in Table 2.
The same reasoning goes for corporations. Since the available income is lower, the ability to invest in growth is also inferior. This contributes negatively to the market capitalization of European companies.
Table 3 - Market capitalization for the EU and U.S. corporations
Europe's inferior capital markets also reinforce the vicious cycle of lower disposable income for individuals and for companies. On the companies' side, the inability to generate sufficient investment funds means that, for instance, venture capital is significantly underdeveloped in Europe when compared with the U.S. Again, that means less jobs, less available income, and all these factors together result in yet another recessive factor: lower women fertility rates. Fertility rates positively impact consumption, the social state and pension sustainability.
Table 4 - Women fertility rates for the EU and the U.S.
The previous rationale lacks a more detailed explanation and further evidence, but I believe that for the purpose of this article, it is enough for the reader to have an idea. Let us now look at some possible counter arguments.
What About The EU Trade Surplus?
The counter argument to the previous rationale would be to say that the policies within the EU are a success because the European Union has a healthy commercial surplus. Let us think about this for a minute.
So, where does the commercial surplus go? The problem with the commercial balance lies on the fact that the surplus is heavily dependent on Germany, and Germany is an exception within the EU. Actually, the German trade surplus is a huge positive driver for the value of the EUR which is a drag on the peripheral economies. The strong currency has mostly benefited Germany. The other countries have only been temporarily benefited while they had money for imports - especially for imports from Germany. This has destroyed several industries in the EU periphery, and it has also contributed to the bankruptcy of the welfare state in the periphery countries.
Now, one can still say that the German trade surplus is going right into its people's pockets, which will drive consumption for products from other EU countries. However, this argument has two flaws. Firstly, the money isn't going into the workers' pockets. According to the Business Insider, the wages in Germany are only the 12th highest in Europe behind countries like Denmark, Ireland and Finland. Secondly, since all the other countries use the EUR, there isn't an automatic currency devaluation that could positively drive exports to Germany.
However, the fertility rates remained low in Germany. So, there's another point where I might be getting it wrong. Or maybe not. I believe the fertility rates remained low mainly due to a society where the companies prosper while workers face pressure to refrain wages. This has been compensated by the influx of immigrants to Germany. Contrary to public belief, immigrants tend to positively influence the economy as they try to fit in, obtaining jobs (increasing production) and becoming active consumers (increasing consumption). Specially, when these immigrants come from within the EU, with high-level qualifications. Therefore, the Germans save money on education, social and health expenses with children and just bring them in as adults to milk their work.
Table 5 - Immigration in the EU
Throughout the previous paragraphs, I have digressed from the title question of this article, but not for a bad reason. I wanted to give the reader my perspective on the U.S. and EU economies in order to be able to support an outlook for the banking industry on both sides of the ocean.
Presently, the EU has been defending a market fundamentalist approach to economics while the U.S. has been far more moderate in this regard. This has led to moderate growth in the U.S. and stagnation coupled with high unemployment in the EU. The current imbalances in the EU are the result of an economic policy being driven by the free market postulate.
The vicious cycle in Europe is resulting in lower production and higher unemployment. This in turn leads to higher expenses with unemployment subsidies in the periphery. Consequently, it generates more expense and less income tax to the public budget. Following the current logic, the next move by the EU will be to reaffirm the free market paradigm and to pressure national governments to cut on public spending (schools, hospitals and other infrastructure). The end result is a community where the people feel they have no safety net. Obviously, individuals in an adverse scenario like this will unconsciously contribute to a stunningly low fertility rate, which is another recessionary driver, thus, creating a vicious cycle in the European periphery. This cycle perpetuation means that the disintegration of the EU will remain a dark cloud in the horizon as long as the current mindset holds.
Let us now see how this will affect the banking industry.
Specific Effects On Banks
The previous research and theoretical exposition has led me to identify three main specific effects on banks:
- The weight of non-interest income on banks: U.S.'s better perception of reality coupled with stronger corporations indicates that its banks will be able to do more than mere money intermediation. The U.S. banks have a very good understanding of the banking business and are able to capitalize on companies demanding more financial services and consumers with more income to spend. Additionally, a historically low unemployment rate will contribute to add consumers to the financial services marketplace. In Europe, banks are behind the fee race. Unfortunately, corporations do not have the same strength as in the U.S. This means less economic activity, and therefore, fewer opportunities to provide services for a fee. On the other hand, lower disposable income means lower consumption and, therefore, fewer opportunities for related financial services. The present regulatory landscape demands robust capital ratios. In this context, banks' profitability suffers. The alternative is to increase customer engagement and to add other financial services. Therefore, non-interest income from new financial services will be key to offset the negative impact from higher capital requirements.
- The impact of the economic context on banks: The economic mess in Europe has resulted in long-duration unemployment. Usually, this has a negative impact on one of the most sensible items on the income statement: loan-loss provision. European banks have been provisioning for non-performing loans at a higher rate than the U.S. banks. Needless to say that this makes a huge difference on the bottom line.
- Interest rate cycle: The U.S. is trying to normalize its interest rates. On the opposite side, Europe is a mess that will need to increase stimulus before it can start raising interest rates. This means U.S. banks will be the first ones to take advantage of the increasing interest rates.
As I look into the present, I do not see any conjunction of forces that might change the course of events in Europe. Therefore, the previous research supports a preference for a basket of U.S. banks during the following six to 12 months.
There is yet another conclusion to take from the previous research: unless an extraordinary event happens, the EUR will underperform the USD. Additionally, the whole rationale is a long view on S&P 500 (NYSEARCA:SPY) as opposed to the European equity indexes.
Disclaimer: The previous text develops a set of insights based on a very complex reality. Some or even several of the probable outcomes identified in this text might not materialize which might compromise the success of the suggested investments. Each investor is solely responsible for the evaluation of the risk of adopting any of the views present in this article.
Disclosure: I am/we are long SAN.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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