Margin Call: Can European Banks Sustain Their Outperformance?
Margin Call: Can European Banks Sustain Their Outperformance?
Over the past five years, the European banking sector—represented by the MSCI Europe Banks index—has delivered impressive returns, outperforming both the MSCI World and the AI-driven MSCI World Information Technology index. With projected dividend yields for FY25 averaging around 5%, compared to just 1.8% for the global index, and earnings growth of 11% over the last 5 years (versus 3% for MSCI World), the sector has offered a compelling combination of income and growth. But is now the time for investors to increase exposure?
Our analysis suggests caution. The sector remains mature, cyclical, and highly sensitive to interest rate movements which remain the primary determinant of bank margins. Over the last 20 years, asset growth—used here as a proxy for loan growth—has averaged just 0.2% annually. This lack of volume expansion has historically translated into modest earnings growth of only 0.3% per annum. However, since 2022, banks have benefited from a powerful tailwind: rising interest rates have driven net interest margin expansion, allowing earnings to grow well ahead of asset growth.
Compound Annual Growth Rates (CAGR) to End-2024:
This surge in profitability is reflected in rising returns on equity (ROE), which have reached levels last seen prior to the financial crisis. Share prices have responded accordingly, with valuations rising from approximately 0.5x price-to-book (P/B) in 2020 to nearly 0.9x by the end of 2024.
Reasons for Optimism
There are still grounds for a constructive view. Interest rates may remain elevated for longer, and anticipated fiscal expansion in Germany could support economic growth, reducing the need for rate cuts in the near term. If the Federal Reserve resumes easing, Europe could experience a rare moment of “Euro exceptionalism”. Meanwhile, capital positions remain robust, and banks continue to make progress on cost efficiency.
But Risks Are Building
Despite recent strength, we believe the upside from here is limited. The interest-rate-driven boost to profitability may prove temporary, especially if rates fall or competitive pressures intensify. In such a scenario, margins will fall, and investors may be left holding businesses whose earnings growth reverts to the pace of asset growth—likely in the low single digits.
There is also the perennial risk of a bad debt cycle, which remains difficult to forecast. Consensus estimates point to earnings growth of just 5% per annum for the sector over the next two years, compared to 9.6% for MSCI World—a reversal of the recent trend.
Valuation Discipline Is Warranted
Investors should demand a discount to book value before committing capital to the sector. Despite significant post-GFC balance sheet repair, banks remain highly leveraged relative to other industries, introducing material risk during downturns. Additionally, with fiscal deficits widening, governments may view the profitable banking sector as a politically palatable target for taxation, especially given lingering public memory of the financial crisis.
Finally, with a 20-year average ROE of just 8%, it’s difficult to justify paying much more than 1x P/B. Valuation upside appears constrained, and selectivity will be key.
Conclusion
European banks have enjoyed a period of strong performance, supported by favourable macro conditions. But with earnings momentum likely to fade and structural limitations reasserting themselves, we believe investors should tread carefully. While the sector may still offer opportunities, particularly among well-capitalised and cost-efficient institutions, broad-based exposure may no longer be justified and that has informed our current underweight to the sector.
Disclaimer
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