European bank investors return to ECB watch

In European markets, relief has turned out to be fleeting in the wake of victory by the market’s preferred candidate in France’s elections, whilst uncertainty has staying power.

The region’s major stock indices acknowledged the result by extending recent run-ups to multi-year peaks, and, for Germany’s DAX, the latest in a string of record peaks. But gains didn't last on Monday

The main task for market participants now is calculating how far the current sell-the-news correction may run. It’s a question faced by investors in all of Europe’s major equity sectors, as the STOXX Europe 600 Index pulls back from a two-year high. But for bank investors, whose shares have been among the best performers so far this year, the calculus is particularly acute.

The STOXX index for the sector was among the weakest performers on Monday, and French banks weren’t spared. One of the primary bullish speculations for banks, and hence for the broader market is whether the European Central Bank is more inclined to signal an unwinding of unconventional policies now that risks from an anti-establishment outcome in France have passed.

Looking ahead, it’s clear that timing could still argue against the removal of monetary policy pressure on banks’ margins before the second quarter of 2018.

To begin with, the ECB is unlikely to show its hand with its next policy announcement. That’s scheduled to coincide with Britain’s general election on 8th June. The bank’s next decision-making meeting after that isn’t till 20th July, around two months before Germany goes to the polls. True, there are signs of consolidating support for Chancellor Angela Merkel ahead of Germany’s federal election on 24th September. Her CDU party solidly beat the social democrat SPD in a vote in Germany's northern state of Schleswig-Holstein on Sunday, whilst the least EU-friendly choice for German voters, Alternative für Deutschland, has struggled with internecine dramas since February.

Political stability in Europe’s growth engine might encourage the ECB to emit a signal about policy changes before the autumn. But by then, it will be on the clock before year end, and will have to weigh the logic of launching a tightening cycle in the winter. The ECB will also be sensitive to the lead up to Italian elections, likely in February 2018 as well. 

The market offered its own signal to the ECB on Monday, by selling sovereign bonds of Europe’s largest challenged economies, France, Italy, Spain and Portugal. Their yields fell early on before rising between 4-6 basis points. Borrowing costs in the countries have benefitted the most from ECB bond buying and investors may have shown a hint of how they might re-position, if the ECB starts to taper.

For investors in the region’s banks then, the least disruptive outcome in France’s election having come to pass is not necessarily an outright green signal. The sector’s leading role in the broader market so far this year keeps the outlook for major stock indices inconclusive too.

Direct investors in European banks and in the sector, by way of exchange-traded instruments, will continue to hang on every word from the ECB for the foreseeable future, but in the nearer-term, with anticipation-fuelled momentum taking a pause, a pullback of bank stocks and sector ETFs looks on the cards.

It’s worth noting that investors barely reacted to promising comments from ECB Executive Board member Yves Mersch on Monday. “Our forward guidance needs to be aligned with an evolving assessment to underpin both the consistency and credibility of our communication” he said, referring to the bank’s officially negative view on whether the Eurozone economy will reach growth targets.

Investors in one of the most liquid European bank ETFs, Lyxor STOXX 600 Banks, which had €808.7m in assets under management as of Monday, will be hoping sentiment does not soften too far. The note, launched in August 2006, has matched the percentage performance of its underlying index this year. It’s also little more than 10% away its record high of July 2015, when premature optimism about a banks’ recovery prospects hit a peak.

• From a technical chart perspective the ETF looks well supported, having recently broken out of a rising channel in place since June 2016, and above support formed of prior resistance dating back to the end of August 2015
• Those solid underpinnings are set to be tested soon however, a view partly based on overstretched momentum oscillators we alluded to earlier
• In the ETF’s case its Relative Strength Index (see sub-chart in red) has strayed outside of its upper boundary, starting the clock for a pullback, although giving no pointers as to the magnitude
• And whilst there are limits in the extent to which most ETFs are correlated with their underlying markets, the failure of the STOXX sub sector to set as many new highs this year may still be a consideration for holders of the fund. (The index is represented in the chart below by a dotted blue line)
• Similarly, attention may be drawn back to the gap that opened up on 21st-24th April—close to the first round of France’s election. Many investors appear to have concluded Marine Le Pen’s election hopes were already toast afterwards, but gaps are usually filled
• The first sign that a more than routine come down may be on the way could be seen if the ETF overshoots the gap (between €104.8 and €109.9)
• More so if a previous support for around €107 ultimately proves to be as unreliable as it was in 2015. Selling that subsequently ensued did not truly abate till last June
• A shallower pullback would be presaged by support at €107 holding, or at worst, simply the reestablishment of the ETF’s (and the sector’s channel trend
• So far this year, it has funnelled underlying bank shares upwards too.