European banking stocks - flying!

About two years ago, in April 2022, 12-month Euribor rate moved into positive territory after being repressed below zero for a little over six years. That move preceded the 50 basis points (bps) rate hike from the European Central Bank (ECB) in July 2022, which changed the deposit facility rate to 0% and initiated the latest hiking cycle. A higher rate environment was always going to lead to different fortunes across industries and individual issuers, however, banks on aggregate, were seen as likely winners of this new rate regime.

Two years on and we can see how European equity investors have responded. During the period of the ECB’s negative policy rates (April 2014 – July 2022), the EURO STOXX 50 Price Index (SX5E) outperformed the EURO STOXX Banks Price Index (SX7E) by 130%. In the period since July 2022, despite Credit Suisse’s demise, the SX7E index has outperformed the SX5E index by 27%. The performance of the SX7E index has been relatively good since July 2022, so much so that the returns exceeded those of S&P 500 Index (by 36%) and even NASDAQ 100 (by 22%). While these are not directly comparable indices, they serve as important benchmarks for global equity investors. The SX7E index trends have also been very similar to those in the UK market, e.g. when comparing the FTSE 100 Index to the FTSE 350 Banks Index over the same period. Post this period of strong returns, average price-to-book valuation multiple in the SX7E Index is at 0.82x, a level which was last seen in 2017-2018, and seen as sustainable only before the global financial crisis.

In the current environment, banks have benefited largely from their ability to increase rates on their deposits at a much slower pace than the pace at which policy rates have been lifted – this has elevated net interest income across the sector through higher margins. Cost of risk has remained benign, which further boosted the recent positive sentiment. Even if non-performing loans were to deteriorate from the current low levels, which forecasts say can be expected, banks have improved their risk absorption capacity through that higher pre-provision profitability. At the EURO STOXX Banks Price Index level, return on equity stood at a little over 11% in 2023 (13.2% in the UK) – a level which we have not seen since 2007. For additional context, during the period of negative policy rates (2014-2022) return on equity for the EURO STOXX Banks Price Index was in the range of 4-6%, excluding 2020 (the “Covid year”) when it ended up at 1.6%. We would note that the current period of higher rates and consistent returns should also lead to more resilient business models, with fewer incentives for management to pursue excessive and unnecessary risks in their attempt to deliver required cost of equity. In simple terms, banks can pursue a boring business model and deliver the required cost of capital at the same time – this was far more challenging during the period of negative interest rates.

Having said the above, we would point out that higher profitability has emboldened some players to already attempt M&A activity, e.g. Nationwide-Virgin Money and Coventry-Coop Bank in the UK, which should consolidate their respective market positions and further reinforce their franchise value. We would also not rule out more M&A activity in the sector given profitability levels available. All else being equal, in our opinion, consolidation should be viewed as a positive development, as it reduces the number of banks and therefore the level of competition, allowing for economies of scale to kick in. Cross-border transactions on the other hand, which normally carry higher execution risks, have not taken off as fast as some market participants have hoped for.

We would also note that it was not only the equity investors that recognised the stronger performance of European banks. In Q1 2024, the average ratio of rating upgrades to downgrades across Moody’s/S&P/Fitch stood at 1.37x in the Western Europe contingent. This figure increases to 2.31x if we focus only on financials in Western Europe, with these latest metrics building on a similar trend we saw during 2022 and 2023.

All in all, as we look ahead into the next 12 months, where we expect the uncertainty around rates trajectory to persists, we take comfort in the fact that European banks have proven their ability to navigate this environment and indeed benefit from it. Any increase in the cost of risk from here will be met with higher pre-provision profitability, which the banks are already reporting in their results. Not only do we think higher stock valuations and ratings are merely a reflection of the trends we are already seeing, but also serve as important indicators that trust has very much returned to the segment after a long period of stagnation in a negative rate environment.

In light of all the above, it should not come as a surprise that Additional Tier 1’s (AT1s) valuations have come a long way (along with other credit markets). The product was first launched in early 2013, so the asset class has mostly seen the period of negative interest rates and challenging operating environment post the Euro zone crisis. For the first time since AT1s have been launched, we are seeing a constructive rate environment, where banks can realistically generate consistent returns and deliver their targeted cost of equity – this is already being reflected in share prices. With that in mind, it would not be surprising to us if these dynamics led to AT1s trading through the previous historical tight levels, as there are fundamental reasons to support this trend.