European banks’ stellar run has seen shares rise over 40 per cent this year, yet they now face new challenges as sentiment is tested by fresh uncertainties in France. Despite this, the sector remains highly attractive to investors, particularly those who invested five years ago, enjoying net returns around 300 per cent compared to 70 per cent for the broader market, according to LSEG data.
European banks: Factors Behind the Recent Rally
The impressive performance of European banks has been driven by strong earnings, thanks to the higher interest rates experienced in recent years before recent cuts. A majority of banks have managed to outperform earnings estimates, signalling positive growth prospects. However, Morningstar senior equity analyst Johann Scholtz warns that this earnings momentum may not last. He anticipates that with falling rates, future earnings might trend towards flat or potentially lower levels, as companies could start lifting their bad-loan provisions due to increased tariffs.
Concerns Over Corporate Defaults
Scholtz expressed concern over corporate defaults, stating, “We definitely expect corporate defaults to increase as a result of tariffs.” Meanwhile, analysts from Morgan Stanley have suggested that Q2 earnings support a view that net interest income (NII) has bottomed sooner than expected, indicating a potential growth resumption in 2026.
A Shift in Interest Rate Expectations
While the earnings growth might be slowing, banks are likely to receive a boost from the European Central Bank nearing the end of its rate-cutting cycle. The era of zero and negative interest rates that plagued European banks for a decade appears to be coming to a close.
Impact of Interest Rates on Bank Earnings
A recent study by the European Parliament highlighted that European banks are particularly sensitive to interest rate changes compared to their U.S. counterparts, with NII constituting 60 per cent of net operating income. Rates have decreased from a peak of 4 per cent but are expected to stabilise above 2 per cent as a potential EU-U.S. tariff deal alleviates some economic uncertainty. MFS Investment portfolio manager Shanti Das Wermes noted, “We’re almost in a sweet spot where banks are able to finally benefit from these deposit franchises that they have, but at the same time, you’re not seeing that stress on the credit side.” This sentiment has supported the shares of banks like NatWest, Lloyds, and Barclays, which have seen increases of 35-50 per cent this year, although they remain below their pre-crisis levels from 2008.
Winners and Losers in the Banking Sector
The rising price-to-book ratio for banks listed in the STOXX Europe 600 Banks index, which has climbed to 1.12 after years of trading below one, reflects growing confidence in the sector’s capacity to generate shareholder value. However, performance among banks has been uneven. German and Spanish banks have seen better outcomes, buoyed by merger and acquisition prospects for institutions such as Commerzbank and Sabadell.
Economic Factors Influencing Bank Performance
Spain’s robust economy supports its banks, which are closely tied to broader economic growth, while Germany’s fiscal stimulus has bolstered growth prospects, with business morale reportedly reaching a 15-month high in August. In contrast, Switzerland’s UBS is grappling with challenges stemming from high U.S. tariffs, maintaining 0 per cent rates, and new capital regulations. This week, French banks faced a significant drop in share prices amid renewed political turmoil, with Societe Generale experiencing its largest daily decline since April.
Perceptions of Risk in the Banking Sector
Generally, investors are perceiving banks as less risky. The cost of insuring against default, as indicated by credit default swaps, has been decreasing. For instance, Deutsche Bank’s credit default swaps, which had surged above 200 basis points earlier in the year during a U.S. banking crisis, are now trading around 54 basis points. A recovery in high-risk AT1 bank bonds, which were questioned following Credit Suisse’s collapse, remains strong. Premier Milton CIO Ian Birrell remarked on these bonds, stating, “They (AT1s) are a lovely combination – great returns. Effectively investment grade paper without the investment grade tag.” Analysts contend that European bank shares are currently at their highest since 2008, with the sector exhibiting more robustness than it did during that period, marked by lower leverage levels.
Investment Strategies Moving Forward
Christian Sole, deputy head of Fundamental European Equity at Candriam, expressed a neutral stance on banks, having invested significantly before the COVID-19 crisis when valuations were low. He remarked, “The momentum is still positive, but the price is not allowing us to be too optimistic,” cautioning that recession risks, although not a forecast, are not currently reflected in market prices. Conversely, Morgan Stanley recently advised investors to consider “buying the dip” in European banks as their shares weaken, suggesting that there may still be opportunities amid the uncertainty.
