European financial stocks have done well this year, up 13% so far and outperforming the broader European market (up almost 10%). The sector is up 32% since its low in Oct-2022. This fast pace of increase has led to “overbought” conditions for the MSCI Europe financials index, going by some technical indicators. For instance, the daily Relative Strength Index (RSI) has spent over two-thirds of the trading days this year above 70. This indicates potentially overbought conditions and increased risk of a price decline. However, we would view any correction as an opportunity to add exposure; we expect the financial sector to outperform the broader European equity market over the next 6-12 months. Here are four reasons why we like European banks:
Interest rates are rising
This is a powerful driver for banks’ earnings growth. With higher rates, new loans extended by a bank can generate higher income. Existing loans on floating rates will generate higher income for the bank. Existing loans on fixed rates would be replaced with loans on higher rates when they mature, resulting in a lagged benefit for banks as they reprice their loan portfolio. Higher interest rates are a major factor for consensus expectations of a 12% earnings growth for the European financial sector this year. The market expects the ECB to continue increasing its policy rate from 2.5% currently to around 3.75% this year and keeping it there through year end. This is consistent with hawkish comments from ECB officials who reaffirmed their commitment to stay on the path of battling inflation. We expect banks’ earnings growth to be a supportive tailwind for the region’s financial sector equities.
Valuations are cheap
The European financial sector is trading at the bottom end of its historic trading range, whether we consider price-to-earnings ratios or price-to-book ratios. Compared to the broader market, the sector is 31% cheaper in terms of its 12-month forward price-to-earnings ratio. Historically the average discount for the sector is 20%. The dividend yield offered by the sector (5.3%) is also superior to that for the broader market (3.5%). The financial sector has been suffering since the Global Financial Crisis (GFC) in 2008. Relative to the broader market, the sector today trades at a level below the trough seen in 2008-2009. To be clear, regulations imposed post-GFC have constrained the leverage that banks can take, which implies lower returns on equity and hence lower valuations. However, we believe the valuation discount is very attractive as rising interest rates act as a tailwind to earnings growth.
Strong balance sheets
By virtue of the post-GFC regulatory restrictions, banks today have far less leveraged balance sheets than during the run-up to the GFC. Hence, they are far less risky. Rising interest rates would predictably lead to more non-performing loans, but we believe the banks have provisioned sufficiently against this. Growing income and strong capital buffers are also likely to protect equity investors from a deteriorating macroeconomic environment. The banks have recently gone through shocks from the Russia-Ukraine conflict and the COVID-19 pandemic and managed reasonably well, working in tandem with the regulators. We do not expect systemic issues to arise in the sector nor do we expect a deep recession, as the economic slowdown from higher rates is essentially instigated by the central bank with the aim to control inflation (and hence central banks are likely to ease off the brakes if a mild recession sets in).
Better macro environment
Last year’s surge in gas prices following the Ukraine-Russia conflict led to concerns about an energy crisis during the European winter. However, an unusually warm winter has reduced the likelihood of energy shortages. In addition, a sooner-than-expected economic reopening in China is a supportive tailwind for European exports. These factors have resulted in easing pressure on European consumers and provided new growth opportunities for European companies. Better-than-expected economic growth would benefit European banks’ earnings as loan volumes pick up, capital market activities increase and the fee-based businesses expand. Although we do expect gradually restrictive policy rates to cause a growth slowdown later this year, the easing of recession risks at the start of 2023 is supportive for the banking sector.
In conclusion, we believe the Europe financial sector would outperform the broader European equities market in the next 6-12 months and investors in European equities should look for opportunities to gain exposure to the sector. Given the likelihood of a short-term pullback due to stretched technicals, those with no exposure to the sector today can look to acquire a smaller initial position and await a pullback to average in. Those with existing exposure should have enjoyed good gains in recent months and can consider adding to their exposure to the sector within a diversified portfolio following a pullback.
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