As we approach year-end it’s a good time to run the rule over the European banking sector
It’s a sector which we’re positive on, for several reasons ranging from regulation and valuations to fundamentals. Let’s break it down:
Fundamentals
We see bank fundamentals as strong – with capital and profitability at decade highs – and the cost of risk remaining below normalised levels. In addition, the wider economic backdrop has been broadly supportive.
Third-quarter earnings were strong with profitability either in-line or better than expected. This was buoyed by resilient net interest margins, strong non-interest income and moderate levels of cost of risk. Asset quality indicators remain solid and we see no real signs of potential deterioration in banks’ results.
In addition, liquidity remains adequate and capital ratios are strong. This is despite significant payouts to shareholders through dividends and extraordinary share buybacks – we expect European banks to pay back up to 80% of profits to shareholders through dividends and buyback over the next two years. The guidance for 2024 given by the banks at their 9M24 results was either stable or slightly better than anticipated. So, while bank profitability has peaked, it should still be strong for the foreseeable future.
Despite interest rates falling, net interest margins are holding up well. This is because banks have been reducing their sensitivity to lower rates through hedging, and competition for deposits has not been intense. We expect to return to a more normalised rates environment, which is good for banks as lending should begin to pick up at rates that are still attractive for them.
The outlook for asset quality has been benign given this declining rate environment and low levels of employment. Our two-year default forecasts for high yield borrowers, which is a good proxy for bank SME loan books, are below normalised levels which is reassuring.
If there were any deterioration in non-performing loans, European banks still have overlay loan loss provisions built up during the Covid-19 pandemic, equivalent to more than half-a-year’s cost of risk, that could be released, plus ample profitability and capital that could also be used to absorb any unexpected shocks.
The impact of the new US government and the possibility of higher tariffs on European corporates exporting into the US is as yet unclear, but could weigh on European GDP with Germany and France flirting with zero or negative growth. However, we believe banks are generally well placed to absorb any emerging risks here.
Regulation
Regulation within eurozone and UK banks has strengthened steadily since the global financial crisis of 2008/09 – in fact we are close to peak regulation. Although there is limited appetite to soften regulations, European banks will likely lobby hard for concessions in applying Basel 4 regulations around credit risk, especially if US bank regulations are rolled back or they fail to adopt Basel 4.
Valuations
Spreads are tight within European investment grade, and senior unsecured bank debt has outperformed year-to-date on a spread-per-unit of duration basis, offering a much-reduced premium relative to history. Pockets of value can still be found in parts of the bank capital structure, for example in higher beta Tier 2 debt.
Technicals (supply and demand)
These are broadly supportive as capital stacks are fully built out and while loan growth has been modest it should begin to pick up. Banks have made good progress on supply this year, with most having completed their funding for 2024 and are pre-funding 2025. Demand for IG credit remains strong with positive net AUM inflows on a monthly basis throughout 2024.
In conclusion, we are comfortable with the outlook for banks on a fundamental basis, and we see them as well placed to absorb any economic weakening. In addition, technicals are currently supportive. However, valuations have come a long way with bank cash spreads having outperformed the corporate IG index year-to-date, so we have trimmed exposure in recent weeks and are focused mainly on Senior Preferred debt, the safest part of banks’ unsecured debt capital stack, as well as select relative value opportunities in Tier 2.
