These are interesting times to invest in the financial sector. Rate hikes, high volatility, uncertainty, and even some shady whispers of a new financial crash make stock prices go on a wild roller coaster ride. The last years have made both Yellen and Draghi famous and even notorious among investors. The U.S. and the European financial markets seem to have been moving similarly so far, but there are a lot of structural differences between the two. Therefore, a comparison in strengths and weaknesses between the two markets. I will start with the bad news: both markets do have shortcomings.
Firstly, there are some general weaknesses both markets have to deal with. Right now, the low interest rates have taken their toll, and banks had to shift from interest-related income to non-interest related income sources. This required a complete rethinking of the traditional banking business model and put a lot of pressure on the sectors' results. Furthermore, a trend of digitization has found its way to this somewhat conservative sector. This required some heavy capital investments and shall probably continue to do so in 2017. But then again, this trend might also provide a chance to attract new customers and modernize existing products. Lastly, there are heavy regulatory measures, which root from the financial crisis. A lot of capital is needed to keep regulatory organs satisfied, which puts pressure on profit margins in times of low income.
When looking at the European financial sector in particular, it is clear that the sector still carries some inherent risk stemming from the Euro-crisis. Firstly there is Italy, which turned down constitutional changes in order to save its oldest bank: Monte dei Paschi (OTCPK:BMDPY). The bank is in trouble for having a high amount of NPLs (non-performing loans) and now has to be bailed out by the state of Italy in order to prevent a second Euro-crisis. To save itself, the bank also plans to issue $15.8 billion of debt in order to boost the confidence of investors and secure its liquidity. The Italian bank is in desperate need for cash (the ECB estimated its need around 8.8 billion euros) and already failed to raise €5 billion via an equity swap last year.
Secondly, there is European problem-child Greece, which is planning a trial return to capital markets in 2017. This is good news, and is definitely a sign of improvement. However, the closer we are getting to date, the more turmoil the case seems to be in. Only three weeks ago, Greece's creditors cut the country's debt relief in half after Prime Minister Tsipras announced spending increases without consulting the creditors. This is only the tip of the iceberg as it comes to the stubbornness of the Greek government, which also promised extra pensions for the Greek people and an exemption of the increase in VAT on the Greek islands. It is clear that Tsipras is testing Europe's patience in order to regain and increase his popularity with the Greek people.
Even though these two European countries seem to be on the (somewhat) right track, there is still much uncertainty as to how close we are to a solution. A "Grexit" is still on the table for saving the European Monetary Union and also a second Euro-crisis could be close if Monte Dei Paschi fails to raise enough capital and goes bankrupt. This uncertainty translates itself into a lot of downward volatility and can take a large piece of the pie that is called return.
As far as weaknesses go for the American markets, there are far less. There are no menacing bankruptcies or stubborn governments threatening the wellbeing of the entire sector. I believe the biggest weakness in U.S. financial markets might be the effect of the eventual Brexit. Once London, the financial heart of the world, will be EU-independent, contractual agreements between the U.S. and Britain will have to be completely renegotiated based on the new circumstances. This will take a lot of effort and time, and may cause for some tax disadvantages.
Secondly, there is still uncertainty on further rate hikes in 2017. This type of uncertainty always messes with the markets, as we saw last year.
Of course, it is clear that these "problems" are only small compared to the difficulties European markets have to endure.
There is one clear strength the American markets can rely on: even though there is some uncertainty about further interest rate hikes in 2017, the interest rate is already up a little. This is a very positive signal for the U.S. banking sector as it will see its profit margins increase again in the coming quarters. Yellen is very positive in general for the American economy, and only recently also reported on how the strong job market are signs of a strong economy. Although she did not report on monetary policy, it is clear that this increases the chances of more interest rate hikes.
The European Central Bank, on the other hand, decided to not yet increase the current interest rate of 0.00%. It did decide to extend the ECB's asset purchase program at the current monthly pace of €80 billion. This pace will be brought down to 60 billion as of April 2017. By buying back bonds, the ECB plans on increasing inflation in order to stimulate the European economy. This means Europe is still some steps behind on the American economy, which seems to be doing well.
Furthermore, the American economy can rely on Trump, who already announced to stimulate the American economy and simplify financial regulations. This again is very good news for the American financials. Of course, these promises have yet to come true before we can see any changes in the companies' results.
I believe that for now, there is still too much risk associated with the European financial institutions. If you're a risk-oriented investor, go for it. However, I believe that the American financial markets have a much bigger potential for increasing their value. It seems we have come to a point where the U.S. markets are getting back on track: interest rates are going up, regulation will (hopefully) be simplified and there are little to no governance issues for the U.S. The American financial sector already took off after the election of Trump, and my guess is that there is still very much more upward potential for this sector.
The European financial market, on the other hand, is one I will be avoiding. The risk on their side is just too big and there are just too many insecurities to make the sector perform well this year.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.