Bank Stock Bulls Will Learn A Lesson From Credit Suisse's Sale

This year's favorite European stock market trade as well as overall sentiment toward the region are at risk after Credit Suisse AG was sold to UBS Group AG so quickly.

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Having been stuck in the doldrums for years, European bank stocks were finally experiencing a time of great opportunity due to higher interest rates. As the sudden crisis surrounding Credit Suisse in the past month has led to UBS taking over this financial giant, it serves as a wake-up call for investors - not only in the region's banks but also in the region's broader equity market, where financials play a significant role.

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Over the weekend, UBS agreed to buy Credit Suisse in what is the first combination of two global systemically important banks since the financial crisis, a deal that has been brokered by the government in order to contain a crisis of confidence among consumers. In the process of taking over the bank, about 16 billion Swiss francs ($17.3 billion) worth of high-risk loans known as AT1s were wiped out, sending a tailspin into the $275 billion market for bank financing.

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With the takeover, a financial juggernaut has been created that underscores the vulnerability of the European banking sector. This year's gains were erased by the Stoxx 600 Banks Index, whereas the Stoxx Europe 600 dropped as much as 2% before regaining most of its losses in London.

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As one of the biggest drivers of outperformance in European equity over the US market, the Stoxx Europe 600 Banks Index rallied 45% from late September through February. Investing in banks in the region was viewed as well-capitalized, secure, and cheap. Bank of America Corp. surveyed regional fund managers in February and found banks to be the most popular sector overweighted.

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Earlier this month, the sudden collapse of Silicon Valley Bank and the closing of Signature Bank sparked a global drop in banking shares, and investor confidence in European lenders rapidly weakened. As Saudi National Bank, its biggest shareholder said it would not invest more cash in the company, Credit Suisse collapsed to a record low and faced massive client outflows.

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Ulrich Urbahn, Berenberg's head of multi-asset strategy, said many funds were longing 'the higher for longer' trades via long European banks and short short-term bonds. Due to the caution of many investors, banking stocks have limited recovery potential.

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Berenberg's strategy is to invest in quality growth stocks and stick to a barbell strategy of being underweight equities, especially US stocks.

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While European banking concerns have been on the rise last week, it's intriguing that US stocks have outperformed the Stoxx Europe 600. The S&P 500 Index rose 1.4%, whereas the Stoxx Europe 600 slumped in its worst weekly decline since September. It could be because European equities have outperformed the US this year, as well as because the Credit Suisse turmoil is viewed as a European issue. S&P 500 futures fell 0.2% today.

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All investors win if a deal fails since another failure could cause further volatility in all asset classes, says Kairos Partners portfolio manager Alberto Tocchio. “The tie-up will definitely calm Europe and banks could bounce in the short term, but volatility will continue to be high for a while.”

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It is likely that the Fed will take a more dovish tone on Wednesday after the latest turmoil, Tocchio added, even though UBS originally wasn't too keen on buying Credit Suisse.

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Emmanuel Cau, a strategist at Barclays Plc, downgraded the EU banking sector today from positive to neutral, saying that liquidity concerns and regulatory concerns may cause banks to be perceived as riskier again.

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Despite the fact that higher rates are expected to boost banks' earnings, Cau wrote in a note that they can also stress the system. Based on financial stability risks, much higher central bank rates are less likely. Thus, banks' earnings are also less likely to grow.

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It is evident, however, that positioning in EU lenders has not decreased significantly this month, and the banking sector continues to have the highest long-short ratio among Stoxx 600 industries, while Barclays reports that most long-only clients are sticking to their overweights. Based on the note, the risk is geared towards the downside in terms of positioning.

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However, Cau pointed out that there are some advantages of the takeover, including that it reduces systemic concerns. Fundamentals and valuations within the European banking sector are strong, so long-term prospects for European banks look promising.

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BNP Paribas SA, HSBC Holdings Plc, and ABN Amro Bank NV are among the banks the Barclays team recommends for now as they are less susceptible to contagion risks.