European banks are poised to release financial results and given their recent performance relative to U.S. financials, they appear to be undervalued. The major U.S. financial companies released their results at the beginning of the U.S. earnings season, with most beating on both the top and bottom line.
Since the beginning of 2018, the European banking sector has underperformed its U.S. counterpart by 10%, and over the past three years, the U.S. banking sector has outperformed Europe’s banking sector by more than 33%.
ETFs To Compare The Sectors
In evaluating the performance between the U.S. financials and European financials, exchange traded funds can track specific financials within the banking, brokerage and insurance verticals. The XLF (financial sector spider ETF), tracks a combination of the largest banks, brokers and insurance companies listed on the major U.S. exchanges.
This exchange traded fund is listed on the New York Stock Exchange. The EUFN ETF (iShares MSCI European Financials Sector ETF) is listed on the Nasdaq and tracks the changes of the major European banks, brokerages and insurance companies). To evaluate the performance of Europe vs. the US financials, EUFN is divided by XLF to track the ratio between the two ETFS. (see chart below)
(Source: Trading View)
Relative interest rates making the difference
One of the main reasons the U.S. financial sector is outperforming its European counterpart is interest rate levels. The U.S. is at the tail end of an expansion where interest rates are rising both on the short end of the interest rate curve as well as the long end of the curve. Higher interest rates allow a bank to borrow short and lend at the long end of the curve, capturing the difference.
In Europe, short-term interest rates are still negative, making it very difficult for the banks to make money using lending as a driver of profits. With the ECB poised to end their quantitative easing program at the end of 2018, and the possibility of rates climbing higher in 2019, European banks are ready to experience accelerating profit growth.
Conclusion: Europe is not ready to catch up yet
Interest rates in the U.S. should continue to normalize according to the Fed. Rates in Europe are ready to begin to increase in 2019 from very low levels. Europe is well behind the U.S. and rates should only begin to catch up by late 2019. While earnings might reflect strong trading gains, and robust investment banking, once interest rates begin to rise in Europe, their banking sector should begin to outperform. It seems unlikely markets will really price in a relative recovery in European banks against US peers until European rates are on a solid trajectory higher.
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