Professional Investor: Now the new frontier lies to the east
Saturday 15 April 2006
From the pioneers of the newly discovered Americas to those trapped behind the Iron Curtain, the West has been seen as the land of opportunity. It often comes as a surprise, therefore, when investors discover that the New Star Global Financials Fund, which I have managed for the past four years, has had barely any exposure to the US.
Detractors may point to my surname and (wrongly) presuppose that its Swiss-French origin hints at some anti-American tendencies. There is, however, an altogether more logical and less xenophobic explanation - concern about the direction of the dollar.
From early 2002, it was clear that currency markets were concerned about the large, growing trade and budget deficits of the US. The US dollar had also been through a propitious period, rising against a euro that still had to prove itself. The dollar was therefore looking expensive, particularly as low interest rates were lending little support to the currency. Moreover, the US stock market was trading on higher multiples than European markets.
When faced with a market where the currency looked under pressure and better value could be found elsewhere, the best strategy seemed to be to avoid the US. This was a brave decision when US stocks represent about a third of the FTSE Global Banks Index. But over the following years, the US dollar fell about 20 per cent relative to sterling, while the European financial sector outperformed its US counterpart.
Does this mean that US banks look good value today? Certainly, there is increasing evidence of consolidation as a fragmented industry seeks to turn regional banks into international giants. In the main, however, American banks are having to contend with a central bank bent on raising interest rates to curb any inflationary pressures.
While this might prove good news for life assurers, since a rise in interest rates and bond yields helps to reduce their liabilities and raise their income, the prospects for the banking sector are less appealing. Higher interest rates are likely to act as a brake on the rampant credit growth that has driven revenues.
A similar story holds for UK banks. While the Bank of England may support the sector with an interest rate cut, the slowdown in consumer credit lending has already arrived. Recent banking results were ahead of consensus earnings but this was because increased revenues from lending to businesses offset a slowdown in the growth of lending to households.
UK banks are not unattractive, since they offer good cost management and high dividends, but the opportunity for outperformance, takeover activity aside, looks limited.
Of far more appeal are the countries that lie to our east. Continental European banks offer attractive growth opportunities and not just among the emerging market countries. We sometimes find it surprising to hear that our nearest neighbours prefer to spend on debit cards. UK credit card debt represents about two-thirds of total credit card debt in the whole of the European Union. If German and Italian banks could entice customers into owning just one credit card, they could reap rewards. The Swiss banks have not lost their magic touch. Half of Asia's billionaires, says UBS, are clients of its wealth-management divisions.
Farther east, making money from the eastern European banks has been par for the course for the past couple of years, as the sector has benefited from convergence with the rest of the EU. Higher economic growth rates and an immature banking market have led to rich profits. The low-hanging fruit has already been picked, however, and investors may find better performance from more southerly banking markets, such as Greece and Turkey.
Credit penetration within Greece is low by EU standards. Greek banks only lend out 89 per cent of their deposits compared with an EU average of 145 per cent, marking a significant opportunity to increase lending. Revenues are also likely to be boosted by rising commission income as banks grow their asset management operations and shift customers away from interest-based to fee-based investment products.
Greek banks are also among the leaders in expansion within Romania, Bulgaria and the Balkan states. Romania and Bulgaria join the EU in 2007. Alpha Bank, the Greek bank, expects earnings from these countries to account for 20 per cent of total earnings in 2009, up from 9 per cent in 2005.
As in Greece, Turkish banks are benefiting from the country's strong rate of domestic economic growth. Investors should avoid getting caught up in the prospects for EU accession, since this is still a distant event, although Turkey's attempts to reform its economy in potential readiness are nonetheless helpful. More fundamental and immediate from an investor's perspective are changes to the tax regime and the mortgage market.
The Turkish government proposes to cut the corporate tax rate this year from 30 to 20 per cent, causing a 16 per cent average upgrade to banking profits for the country's three leading banks. It also intends to equalise the tax burden on domestic savings instruments.
This should trigger a shift in savings from government securities into bank deposits and mutual funds. This would create a cheap source of loan funding as well as generate greater commission on investment products.
In 2005, mortgage lending in Turkey represented 1.9 per cent of the gross domestic product. The corresponding figure in the UK is 80 per cent, while in Hungary and Poland it is 9 and 5 per cent respectively. Demand for housing loans should therefore continue to grow.
Clearly, investors need to be mindful of the risks of investing in less developed markets, but with tighter monetary policy in the US creating a headwind for US banks, there remains considerable potential for European banking stocks to continue to outperform.
Guy de Blonay is manager of the New Star Global Financials Fund
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