European Banks: Hard Work Pays Off

The Calamos Global Equities Team believes:

• Overseas equity markets are positioned to harness many tailwinds (including US policy shifts and a sideways-to-weaker dollar), and European banks should be key beneficiaries.
• Europe’s banks have navigated a long road to recovery, and the macro backdrop is improving.
• Many European bank stocks are positioned for sustained upside, supported by fundamentals and valuations, as well as the potential for a less burdensome regulatory environment.

Since bottoming in the fall of 2020, European banks have steadily outperformed the broader European market (Figure 1). And they are gathering steam, with over half of their outperformance coming within the last year.

Figure 1. European bank stocks: Outpacing the European Equity Market

Past performance is no guarantee of future results. Source: Bloomberg. The European equity market is represented by the STOXX Europe 600 Index, which tracks the performance of large, mid and small cap companies in 17 countries in the European Region. Europe bank stocks are represented by the STOXX Europe 600 Banks Index, which includes companies within the STOXX Europe 600 Index involved in the bank sector. Data is price return.

Our team believes that European banks still have plenty of room to run. The total return for the banks still trails the broader European market by more than 100% from the pre-Global Financial Crisis (GFC) high in mid-2007. From a valuation perspective, the aggregate European bank price-to-earnings ratio is still trading near historic lows compared to the broader European market (Figure 2) and on an absolute basis.

Figure 2. European bank stocks are attractively valued

Past performance is no guarantee of future results. Source: Bloomberg. The European equity market is represented by the STOXX Europe 600 Index, European bank stocks are represented by the STOXX Europe 600 Banks Index.

It’s been a long road to recovery …

The European banking system took much longer to recover fully from the GFC, and the banking sector has been largely unloved by investors for over a decade. In short, Europe did not have the proper backstops to allow the banks to recognize losses and recapitalize their balance sheets more aggressively. This resulted in a negative feedback loop that prolonged the economic recovery in Europe. The weakened banking system could not adequately support the economic recovery and the sluggish economy made it harder for the banks to generate sufficient profits to rebuild their capital positions. In addition, a persistently cautious—and arguably onerous—regulatory environment further impeded the growth outlook for the banking system.

… But the European banks are on much stronger footing now …

The pandemic was a key turning point for the European banks. Increased government support combined with the higher rate environment of the past couple of years drove a ramp in profitability that allowed the banks to finish cleaning up their balance sheets. Europe’s banks are now in a much healthier position, but Europe’s economic growth outlook and thus aggregate loan demand has been held in check by increased geopolitical and global trade uncertainty combined with a more restrictive fiscal/monetary environment.

In the current environment, banks have focused on returning profits to shareholders via increased buybacks and dividends. The ramp in profitability and capital returns has translated to notable market outperformance over the past few years, but so far, the re-rating of Europe’s bank stocks has been limited by investor skepticism that current profit levels can be sustained without healthier underlying economic and loan growth.

… and now the economic and loan growth outlook is improving

Our team is now growing more optimistic that increased fiscal spending plans combined with a more accommodative monetary policy will help jump-start the European economy. The improving economic growth backdrop should translate to increased loan demand and also reduce the risk that the European Central Bank needs to cut rates more aggressively and thus further strain bank margins to support growth.

In addition to the improved growth and rate outlook in Europe, there is also growing optimism among market participants that the Trump administration is likely to spark a more favorable regulatory environment globally. This less onerous regulation would likely provide banks with more capacity to fund increased loan growth and shareholder returns.

Conclusion

With the hard work behind them in reaching healthier balance sheets, combined with rising optimism of improved loan growth, the European banks should be well positioned for a period of both rising earnings growth and a re-rating. We’re finding many ways to participate in this exciting opportunity set across our portfolios.