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The recent Brexit referendum was a historic moment. In a very tight vote, Britain voted to leave the European Union, 51.8%-48.2%. However, the financial markets were not pleased with the outcome. Markets collapsed after the vote, with the Dow Jones Industrial Average losing 1,000 points across a two-day period.
This was a huge shock to the markets. Leading up to the referendum, the markets had priced in the remain vote to win. Moreover, Britain leaving the EU places a great deal of uncertainty on the global markets. Moving forward, there is fear that other nations in Europe could decide to follow suit, and leave the EU, now that Britain has set a precedent.
Brexit is widely expected to lead to tighter financial conditions in Europe. Interest rates are falling through the floor, the British pound collapsed against the dollar, and equity markets are reeling. For all these reasons, avoid European bank stocks like Royal Bank of Scotland (NYSE: RBS), Banco Santander (NYSE: SAN), and Barclays (NYSE: BCS).
Recession Could Hit European Banks
In the aftermath of the Brexit vote, many economists have adjusted expectations for Europe going forward, and are largely expecting Europe to fall into recession as a result. The one sector that this would harm the most would be the financial sector.
This is why European bank stocks like Royal Bank of Scotland, Banco Santander, and Barclays fell 30% or more in the two market trading days following the referendum. These banks were challenged coming into 2016, due to the ongoing tepid economic climate in Europe, and the Brexit will likely only make things worse. Europe is languishing with persistently low inflation and there is even the threat of deflation.
Earlier this year, the European Central Bank announced it would continue to aggressively pump money into the European economy. One measure employed is negative interest rates, which are going to be very difficult for European banks, and Brexit will only put more pressure on economic conditions in Europe.
Royal Bank of Scotland lost $2.6 billion last year, due primarily to litigation and restructuring costs. The bank is making significant efforts to get out of businesses that got it into trouble during the financial crisis, but this has come at a steep cost. The Brexit vote only complicates Royal Bank of Scotland’s future outlook.
Meanwhile, Barclays lost $530 million last year, a far worse loss than the year before. The company generated -0.7% return on average equity for 2015, down from -0.3% in 2014. Things haven’t been much better to start this year, as Barclays’ core net income fell another 7% in the first quarter 2016.
Banco Santander was a rare example of a European bank showing glimmers of progress heading into 2016. It had successfully improved its loan portfolio to improve its balance sheet–credit volume rose 6% last year. Commercial revenue increased 8%, and Banco Santander’s loan-loss provision declined 4% last year. This helped boost underlying earnings by 13% in 2015, but the Brexit vote could reverse the progress made over the past year.
European Banks: Yields Seem Enticing
There is a good chance that the Brexit vote will throw Europe into a recession, and if that happens, the banking sector should be avoided.
Investors might be attracted to European bank stocks because they sport very high dividend yields. At its 2016 annual meeting, Banco Santander announced its intention to raise its dividend by 5% this year, and the stock now yields 5.7%. Similarly, Barclays yields 5.3%.
While these lofty dividend yields are enticing, they could also be taken as a warning signal. Their elevated dividend yields are due to their collapsing share prices, and not dividend growth. This is an indication that their fundamentals are on rocky ground, and the Brexit vote only exacerbates the risk. As a result, only investors not afraid to take significant risk should consider buying European banks.