The European Union has some major issues that will eventually have to be solved, but not by kicking the can down the road, as is being done at present. The problems include the high rate of non-performing bank loans (NPLs), Brexit, and use of a single currency by all EU nations. These issues will ultimately place a great deal of stress on the EU financial system. The proposed pairs trade is intended to take advantage of the messy situation in Europe by going long the Financial Select Sector SPDR ETF (NYSEARCA:XLF) while shorting the iShares MSCI Europe Financials Sector Index ETF (NASDAQ:EUFN).
The weighted average NPL ratio for the EU as a whole was 5.7% in 2016, but with high dispersion across different countries.
A cross country comparison suggests that the average NPL ratio is much higher in the EU than in other global jurisdictions.
NPLs are a problem at multiple levels: at a micro prudential level, heightened NPLs are associated with lower profitability and lower efficiency; at a macro level high levels of NPLs are associated with stagnant growth as capital is tied up with NPLs and not funding new lending into the real economy; finally, for consumers, proactive engagement on NPLs by banks can help avoid the situation of paying interest and fees on an asset that they may eventually not own……Moreover, a decline of stock prices can negatively affect bank asset quality. Finally, an increase in lending interest rates tends to increase NPL.
While Brexit is still a long way off, the ongoing uncertainty will have an impact on banks, not only in the UK, but also the rest of Europe. US banks have grown relative to European banks for several years.
Some analysts believe that Brexit will see the titans of Wall Street extend their lead. "The biggest US banks will have an epic market share opportunity versus weaker European banks," says CLSA's Mr. Mayo. "For all the extra cost and complexity for US banks, they can still benefit proportionately."
Euro - single currency
The problem with using a single currency through the European Union is well known. It eliminates the possibility of devaluing a country's currency in the face of a recession, making economic hardship longer and deeper. Greece is a good example.
Deregulation in the United States
President Trump has made it known that regulation is crushing American business. Several sectors will benefit from deregulation, including oil and gas and the financial industry. Below is a quote from Deregulation: A Slam-Dunk For Investors.
There are several financial executives in the new cabinet who have direct experience with burdensome regulations and will assure that it gets immediate and sustained attention.
Rising Interest Rates
It is generally understood that rising interest rates are good for banks. As interest rates are expected to rise in 2017, US bank profits will rise accordingly. It is estimated that Bank of America (NYSE:BAC) alone will earn $5.3B more with a rise in interest rates of 1%. JPMorgan Chase (NYSE:JPM) stands to earn $3B more, and Citigroup (NYSE:C) would earn $2B more.
On the other hand, even if interest rates remain flat, the big US banks are healthy and will do well in 2017.
The chart below represents a time series of XLF divided by EUFN. The trend has been bullish for several years, and the ratio is currently sitting at the lower trend line which acts as support. The trading pair should go up from here.
XLF / EUFN time series
The trade should be closed out for a loss if the support level shown in green on the chart is breached. This is expected to be a long-term trade, as Brexit and the Italian bank situation will take a long time to play out, perhaps years.
One thing of note is that the Global Industry Classification System (GICS) was restructured back in the fall of 2016, resulting in REITs (except for mortgage REITs) being moved out from under the financial sector. As a result, the Financial Services Select Sector SPDR ETF (NYSEARCA:XLFS) was restructured, and REITs were split off from the ETF. To account for this, I have also examined the chart for the Financial Services Select Sector SPDR Fund, which is more representative of what XLFS holdings are now. Unfortunately, XLFS has only been around since October 2015, making technical analysis more difficult.
Time series for XLFS / EUFN
The above chart shows that XLFS / EUFN may meet resistance at its current level and retreat. But this will be short-lived. In order to obtain a higher level of confidence, I decided to look at both time series individually.
Stock chart of XLFS
XLFS is experiencing a breakout, but will probably retrace back to the nearest support level before further gains are made. (See chart above.)
Stock chart for EUFN
EUFN is currently sitting at a resistance level and near a downward trendline. I believe that the trend for EUFN will continue down.
As a result of the above exercise, I feel comfortable that either XLF or XLFS could be used for the long side of the position. I will stick with XLF due to its higher Assets Under Management (AUM)/liquidity.
The purpose of this trade is to take advantage of the problems in the EU financial system. It is prudent to examine the country exposure of EUFN.
EUFN exposure by country
As can be seen from the above figure, EUFN has 30% exposure to UK financials. Given that Brexit, if or when it occurs, will cause significant stress for UK banks, I believe that this level of exposure will be a big deal.
The other two eye sores are Spain and Italy, with 10% and 5% exposure, respectively. Rising interest rates will cause NPLs to rise, and banks in these two countries will need to be recapitalized.
Risks for this trade
There are several risks to the US banking system. Among them are a rapid rise in interest rates leading to falling bank asset values, increased competition from foreign entities, ongoing and changing cybersecurity threats, and continued incremental easing in underwriting standards that presents increasing credit risk.
In the EU, the biggest risk is that the economy and politics will return to "normal". Good economic growth and demise of populism could send the banking system into a state of normalcy, leading to outperformance of the financial sector.
Summary and Conclusions
The European Union has some major issues including the high rate of non-performing bank loans (NPLs), Brexit, and use of a single currency by all EU nations.
The ongoing uncertainty of Brexit will have an impact on banks, not only in the UK, but also the rest of Europe.
President Trump has made it known that regulation is crushing American business. Several sectors will benefit from deregulation, including oil and gas and the financial industry.
EUFN has 30% exposure to the UK, 10% exposure to Spain, and 5% exposure to Italy. Banks in these 3 countries will come under stress with Brexit and rising interest rates.
The proposed trade is long the Financial Select Sector SPDR ETF while shorting the iShares MSCI Europe Financials Sector Index ETF.
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.