iShares MSCI Europe Financials Sector ETF: Key Discussion Points (NASDAQ:EUFN)

Banking is very good business if you don’t do anything dumb. – Warren Buffett

The iShares MSCI Europe Financials Sector Index ETF (NASDAQ:EUFN) is a ~$700m valued ETF, offering coverage to over 75 European-based financial stocks. Banks account for the largest chunk of this ETF with a 46% weight; the rest of the ETF is exposed to insurance firms and diversified financial firms.

Subscribers of The Lead-Lag Report would note that every week I share a chart highlighting the relative strength of European financials and US financials; you’d be interested to know that this ratio is at rather lowly levels implying that European financials appear to offer good value. Should you then be considering this cohort? Well, there are both good and bad aspects to pursuing EUFN at this juncture, and in this article, I’d like to touch upon some of the key narratives that could impact this ETF.

Key Discussion Points

Last month, I had put out a tweet on the timeline of The Lead-Lag Report highlighting how inflation in the Euro regions was at record highs of 7.5%; if you thought that figure was bad enough, then the May reading which came out yesterday was even worse at 8.1%, and also above market expectations of 7.8%! In fact, there are some regions in Europe where inflation is now actually around the 9% threshold.

As noted in The Lead-Lag Report, even before this report came out, there were certain bankers within Europe complaining that the ECB wasn’t being aggressive enough with its rate hike plans. It was mooted in some corners that rates could be hiked by 25bps in the July 21^st ECB meeting, but now I wonder if this will be dialled up even more to a potential 50bps hike?

Prima facie, a more aggressive pivot on rates across Europe should provide a useful fillip for the net interest margins of European banks, but as noted in The Lead-Lag Report, things are not as cut and dry, given the underlying economic conditions there.

Firstly, do consider that the issue with the Eurozone inflation is that it’s not particularly a demand-driven issue, and much of this is on account of supply-side dynamics. In fact, one could argue that the dynamics on the demand side are so precarious that the ECB runs the risk of shooting itself in the foot if it tightens too quickly. Look at something like consumer confidence; this has been in negative territory for so many months now, but over the last three months, the pressure has been particularly pronounced.

Then you consider the growth dynamics within Europe; this is a region that only recently delivered minuscule growth of 0.3%; now even if banks were able to extract more interest per loan given (assuming a pivot to higher rates), can one expect to see a meaningful expansion in loan growth when your consumers are very low on confidence, and your economy is dwindling at sub 0.5% growth rates?

Then there’s also the Russia-Ukraine narrative to consider as it has both positive and negative connotations. As you would imagine, a lot of these European-based lenders have strong exposure to those regions, and now have to deal with heightened credit provisions to mitigate risks there. As you can see from the image below, aggregate credit provisions for 14 European banks currently stand at their highest point in 5 quarters. Higher credit provisions also mean that banks could potentially have lesser room to indulge in higher capital distributions or buybacks. In fact, EUFN’s top holding HSBC (which has an 8% weight) recently mentioned that it is unlikely to indulge in further buybacks in 2022.

Whilst distribution risk has picked up, this crisis has also resulted in a spike in volatility; and when you see a spike in volatility, one almost always witnesses an increase in trading activity. Note that these European banks have been chief beneficiaries of the recent trading boom, with Euro-based trading revenue growing at a much larger pace than what was seen in the US. As there doesn’t appear to be any end in sight with the Russia-Ukraine war, and since there are also other global headwinds floating around, I’d expect volatility to stay elevated and thus aid this trading boom.

EUFN holders will also be encouraged to note the improving conditions of the Euro; I mentioned recently in The Lead-Lag Report that the Euro was approaching parity and I think it is now due a catchup, particularly as the ECB looks set to embark on an aggressive path of rate hikes.

Conclusion

Whilst the fundamental backdrop of European financials looks rather mixed with a negative bias, one can’t say the same about the valuation and income perspective, as it looks a lot more attractive than its peers in the US. Firstly, consider the superior yield differential of over 200bps between EUFN and the SPDR S&P Bank ETF (KBE). Incidentally, EUFN’s current yield of over 4.5% is at its highest point in nearly two years and could serve as a very useful parachute if things go awry here.

EUFN is also a lot more attractively valued, with its constituents trading at a forward price to book value of only 0.72x, a whopping 69% discount to the corresponding multiple of KBE.

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