Banking on European Profits

Investing Daily Article of the Week

by Ben Shepherd, Investing Daily

After the relative success of our own quantitative easing program, the European Central Bank has taken a page from the Federal Reserve’s playbook and announced that it will begin buying $66.3 billion worth of bonds a month starting Monday. The idea is the injection of cash, to the tune of $1.1 trillion eventually, will lift all boats and create as little market distortion as possible.

The announcement comes even as Eurozone economic data is looking a bit better, with gross domestic product showing some growth and relatively stable inflation. But the ECB is committed to following through with its QE program, leading the continent’s stock markets to get off to their best start to the year since the 1980s.

That’s a big reason why U.S. stocks have become more volatile and Treasury yields have been rising of late:: Some global investors are pulling out of our markets and focusing on Europe instead.

You can hardly blame the money for going where the best returns are likely to be made. While it’s not exactly an apples-to-apples comparison – the U.S. Fed only had to worry about stabilizing one country, while the ECB has to deal with 19 – our own QE is the major reason why our own stock market has shot up by more than 170% since bottoming out in 2009.

As QE drives down bond yields while flooding the financial system with liquidity, all that cash naturally flows into the stock market.

Some of the biggest winners in the QE dash for cash will likely be the region’s major banks, based on our own experience. For instance, while the S&P 500 is up more than 170% and the Dow has gained just shy of 150%, Citigroup has gained more than 250%, while profits have skyrocketed.

True, an improving economy contributed to those gains, but a couple of recent studies show that Wall Street firms such as Citigroup made as much as $650 million just in fees for selling bonds to the Fed.

Executives at Banco Santander and HSBC Holdings, two of our Global Income Edge holdings, are no doubt looking forward to similar opportunity in their home markets.

Based in Spain and currently yielding 11%, Banco Santander (NYSE: SAN) has managed to stay profitable throughout the European economic crisis, largely thanks to its robust Latin American operations. Overall, between 2011 and last year, this hemisphere was responsible for more than half of its profits.

Last year saw a marked improvement for the bank, as its net profit in its home Spanish market nearly tripled. Mortgage lending showed strong gains and-it cut its provision for bad loans from $13.6 billion in 2013 to $11.6 billion last year.

Largely thanks to that improvement, coupled with the positive affect of Europe’s new QE program, analysts expect Banco Santander’s earnings to grow by nearly 15% this year and 18% in 2016. And if Europe’s QE experience is anything like our own, those estimates are conservative.

Now is an ideal time to buy the bank’s shares, since they’ve sold off sharply following a dividend cut at the end of the year. But with the bank on firmer financial footing even as the ECB extends a helping hand, the dividend payout is likely to quickly recover.

While shares of London-based HSBC (NYSE: HSBC) haven’t been quite as volatile as Banco Santander and offer a lower 5.7% yield, the bank has faced some troubles of its own. It’s found itself in the center of several scandals over the past few years, recently paying $809 million to settle an investigation into its role in fixing international exchange rates.

But, as the second-largest bank in the world with a leading market position in Europe, much of the cash that the ECB is pumping into the region’s financial system will likely pass through HSBC. So while it is widely expected that legal costs will continue weighing on the bank’s earnings over the next couple of years, here in the U.S. many of our banks still managed to report surging profits despite paying massive settlements over our own mortgage crisis.

If you want to take a cynical view of the situation, you could say that the ECB is essentially subsidizing the HSBC’s legal costs. If you’re more pragmatic about it, though, it’s adding extra room for profits.