Current valuations imply that banks are a cyclical business, and that customers may struggle to repay their loans as economic conditions deteriorate further. Whilst a deterioration in banks’ asset quality in 2023 is likely, our view is that banks have significantly improved their fundamental position over the last 15 years, including a strengthening in lending standards, liquidity levels and capital position. In our view this will allow them to absorb any increase in defaults, given their solid balance sheet position.
In fact, the banking sector in Europe is now in a place that we have almost never seen before in terms of balance sheet quality. Banks have been deleveraging ever since the Global Financial Crisis (GFC), selling underperforming assets, as demonstrated by average non-performing loan exposures decreasing from 4.5% five years ago to below 2% currently.
This is to a large extent driven by tighter regulation than before the GFC, with rules such as Basel 3 forcing banks to accumulate a substantial amount of capital and to reduce risk.
The other dynamic which has characterised 2022 and will continue to be very important next year is the trajectory of interest rates. Higher interest rates are positive for bank earnings, and this has already been reflected in banks’ strong third-quarter earnings. We would expect this to continue into Q4 and in 2023, allowing banks revenues to continue to increase. On the other hand, it is likely that in 2023 asset quality for banks will start to deteriorate due to the weaker economic conditions and as higher interest rates increase the repayment burdens for borrowers. Whilst the sub-investment grade corporate sector might suffer the most from economic slowdown, we consider it prudent to favour large and systemically important institutions with ample capital buffers and diversified balance sheet. Whilst smaller, second-tier banks in Europe have strengthened their fundamental position in recent years, they are more vulnerable to an asset quality deterioration.
In terms of our CoCos strategy, we think it makes sense to look at gradually increasing duration as we expect that central banks will have to shift to a more dovish rates policy in 2023 as the economy weakens and inflation pressure eases. We also think that credit selection is of paramount importance, and it is a good time to own higher quality CoCo issuers — to sacrifice a little yield if necessary to stay with the strongest institutions. We think that this will potentially allow CoCo investors to lock-in very good yields without taking excessive risks in an uncertain macro environment and volatile markets.
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A key feature of Jupiter’s investment approach is that we eschew the adoption of a house view, instead preferring to allow our specialist fund managers to formulate their own opinions on their asset class. As a result, it should be noted that any views expressed – including on matters relating to environmental, social and governance considerations – are those of the author(s), and may differ from views held by other Jupiter investment professionals.
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