Morgan Stanley picks Lloyds and Barclays as banks play "catch up"

Morgan Stanley thinks European banks might now "start to play catch up" after an unusual period of underperformance in an improving macroeconomic environment.

Although Greek concerns remain, the US investment bank believes some concerns about the banking sector are easing, such as deflationary risks, pressure on net interest margins and concern about capital needs, and that positive drivers are becoming more visible.

"Banks have underperformed on the back of falling inflation expectations, but should gain as deflation fears ease, due to ECB easing and stabilizing oil prices," a note from Morgan Stanley analysts said.

Analysts said concern about downward pressure on net interest margins due to the European Central Bank's quantitative easing may be justified, but should partly be offset by falling bad-loan provisions.

While acknowledging that uncertainty about capital needs remains, with the ECB now in charge of regulation, the analysts believe "parts of the sector can surprise on the upside on capital and dividends".

As well as stronger macro momentum, positive drivers for the sector include banks starting to look attractive as dividend plays, offering the fourth-highest yield in the market, as low bond yields incentivise income investors to focus on equity yield.

Rather than plays on improving net interest margins, they prefer stocks with potential upward surprises on dividends and restructuring, chiefly ING, Intesa Sanpaolo, Lloyds Banking, Bankia, UBS, Natixis and Barclays, plus the London Stock Exchange from the wider financials sector.

Across the sector as a whole, Morgan Stanley thinks valuations still look attractive, with banks trading at a 50% price-to-book discount to the market, close to a 20-year low, and the P/E relative has just reached the lowest level since March 2009.

The analysts' least-preferred list, which largely centres on concerns around earnings downgrades and dividend misses, includes Standard Chartered, Banco Popular, HSBC and Banco de Sabadell, plus Aberdeen Asset Management from the wider sector.