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For many years, many investors considered European banks too risky to own, due to political interference, a sluggish economy and self-inflicted suffering.
At some point, there is a risk of not owning them anymore as the sector’s outperformance begins to reach benchmark returns for those on the sidelines. This risk is growing.
Stock prices have soared this year – and first-quarter results did little to dissuade those convinced of the banks’ attractiveness. While the ECB is expected to begin cutting interest rates as early as June, bond yields have risen this year along with renewed inflation fears.
This is helping to support net interest income, with Spanish and Italian banks such as UniCredit raising their profit outlook on Tuesday. These markets, where loans tend to be tied to market interest rates, accounted for seven of the top ten stock prices this year.
Loan defaults remain subdued. Economies are performing better than expected and unemployment is low. Overall, provisions for loan books could increase by a few basis points to 0.49 percent this year, UBS believes.
Combined with looser regulatory policies, this results in higher returns for investors through dividends and buybacks. The sector offers a dividend yield of 7 percent this year – almost double what it would be if buybacks were taken into account. The Stoxx 600 banking index is up 16 percent year to date, outperforming the broader market by 10 percent, with the sector’s valuation approaching 1x tangible book value.
The outlook for Europe’s investment banks is less rosy. It’s true that changing interest rate expectations earlier this year led to a flurry of activity in debt capital markets as companies rushed to secure lower interest rates. This helped Deutsche Bank’s first-quarter revenue from both debt issuance and transaction advisory rise 54 percent year-over-year. UBS investment banking revenues were 25 percent better than expected.
The rush on the debt capital markets is already easing. There wasn’t that much going on with the share issue. Europe is lagging behind the US in recovering deals and IPOs. European institutions posted a mixed performance compared to the U.S., where investment banking revenue rose 27 percent in the first quarter.
Europe’s banks have still not shaken off the reputation of making unforced errors. Deutsche Bank had risen by a third this year until a 1.3 billion euro provision last week related to its takeover of Postbank sent shares down almost a tenth.
Europe’s banks are now seeing rising returns and investors’ fear of missing out is on their side. However, your penchant for unpleasant surprises remains.