“So, there he is. Risen from the dead. Like that fella….E.T.”

Father Ted’s observation of a post-comatose Father Jack* could also be made of European banks, which have had a revival in relative performance following a prolonged period in the wilderness. We consider this reassessment of the sector’s prospects as justified and continue to see an attractive risk/reward for European banks (we are overweight in the Polar Capital Global Financials Trust). We expect the strong relative performance to continue.

The transformation in European banks' profitability, along with higher capital levels and a more stable regulatory environment, has put them in a much stronger position to both expand their balance sheets and return capital to shareholders. This attractive combination of lower-risk earnings and higher total shareholder return has not gone unnoticed by investors, albeit the sector continues to trade at depressed valuations.

MSCI Europe Banks Index versus MSCI Europe Index (in euro terms)
Msci Europe Banks Index Versus Msci Europe Index
Source: Bloomberg, April 2024.

Banks are cyclical businesses, but the shift out of a decade of monetary policy experimentation with negative interest rates has led to a step-change in profitability (12.3% return on equity (RoE) in 2023 versus an average RoE of 4.9% in the period 2009-19). While interest rates, and net interest margins, are likely to have peaked, there is asymmetry to interest rate sensitivity on the way down, as banks are more sensitive to the first few rate rises (diminishing benefits after the first 250 basis points (bps) of increase) and the interest rate hedges placed have locked in the benefits of higher rates. Consequently, a normalisation in interest rates to 2-3% would continue to provide a very attractive backdrop for bank profitability.

Another significant change for European banks has been a more settled regulatory environment. The decade following the global financial crisis (GFC) was characterised by political bank-bashing and reregulation. It was a full-time job for sector specialists just keeping up to date with all the new acronyms coming out of the European Central Bank (ECB) as part of their regulatory tightening. In contrast to the previous decade, when capital generation was used to strengthen balance sheets (rather than reward shareholders), European banks now offer a yield of >10% (including dividends and buybacks), a level we also expect to be sustained next year.

European banks’ capital return is higher versus pre-GFC yet the market cap is lower
European Banks’ Capital Return Is Higher Versus Pre Gfc Yet The Market Cap Is Lower
Source: Autonomous, March 2024.

Finally, European banks have outperformed but have not rerated, with valuations remaining at low levels. European banks trade on 7.4x 12-month forward price-to-earnings (P/E), well below their long-term average in spite of the recovery in profitability. We suspect a rerating may require greater visibility on the interest rate path combined with evidence of asset quality resilience, although investors are being paid to wait given the high level of capital return. While the experience during the GFC lingers long in investors’ memories, current valuations do not reflect the shift in the sector’s risk and earnings profile, providing an attractive risk/reward for shareholders, in our view.

*Father Ted; season one, episode six: Grant Unto Him Eternal Rest.