ab12 February 2024Global Research and Evidence LabGlobal Equity Derivatives StrategyAll the way to the bank: Appealing options for EU vs. US BanksAs featured in our 2024 Global Equity Derivatives OutlookTrade idea to consider (indicative OTC pricing vs. forward a/o 9 February):SX7E/KBE Jun 105% call switch, ~1.5:1x ratio for flat premium (buying SX7E; SX7E forward ref = €111.96, KBE forward ref = $44.11)Stronger returns, cheaper vol, better metricsEU Banks have outperformed US Banks by nearly 20% total return over the last year – The key drivers were the US banking crisis in March 2023 and the higher for longer rate backdrop (Figure 1).US Banks continue to face headwinds from Regional Bank uncertainties. This has kept US Bank implied volatility at a relative premium to EU (Figure 2).Fundamentally, expectations for EU Banks EPS continue to trend higher relative to US Banks. Despite this, EU Banks trade at a forward P/E and P/B valuation discount (Figures 3-8).More bullish across the pondJason Napier (EU Banks Analyst) continues to see significant value in EU Banks (~20% upside to target). He sees banks discounting excessive concern about falling policy rates and peaking NIMs this year. Erika Najarian (US Large Cap Banks Analyst) has a less optimistic outlook for US Banks (~10% upside to target), with a large cap/high quality bias.Risks include: US elections spurring a rotation into US Financials (similar to 2016/2020), rate cuts alleviating pressure on regional bank balance sheets, and renewed investor belief in 'US exceptionalism'. For EU Banks, policy rates coming substantially lower hurting NIM expansion, a sluggish macro backdrop, and tax/regulation changes are the key foreseeable risks.Higher for longer incrementally positive for EU > US BanksWe recently highlighted relative value ideas to fade rate cuts, notably KBE or KRE/XLF (in put switch format) as a long quality-biased pair within US Banks. A higher for longer rate environment remains a headwind to US Banks generally because of the balance sheet asset sensitivity and credit concerns within regional banks. We therefore expect limited upside in KBE given their Regional Bank exposure (~19%), while we expect EU Banks (SX7E) could continue to benefit from this higher for longer/re-acceleration narrative (Figure 9).KBE implied volatility trades at a substantial premium to SX7E. This allows for premium-neutral leverage to SX7E upside. Historically, this has been a profitable opportunity (Figures 10-12).Our Market Cookbook suggests there is ~8% US banks downside but modest upside to EU Banks in the coming months if our expectations for slower growth are realized. This presents a ~10% potential return differential directionally. The 10% implied volatility premium of US banks means this strategy looks favorable as a call switch – selling US Bank ETF (KBE) call options to fund EU...
