Exploring the outstanding performance of European bank stocks: Is it the right time or has the peak already passed?

According to Zhitong Finance APP, European bank stocks have surged over 40% so far this year, but with renewed uncertainty in the French political landscape, market sentiment has been impacted, and the sector will face challenges.

Nevertheless, investors may still find it hard to ignore the attractiveness of this sector—it remains the best-performing sector in Europe this year. Data from LSEG shows that if investors had bought European bank stocks five years ago, the net return would be about 300%, compared to a return of only 70% for the broader Stoxx index during the same period.

The following will analyze the logic behind the recent rise in bank stocks and look ahead to future trends.

Profit rebound may be difficult to sustain

This round of gains is attributed to strong earnings performance—mainly benefiting from relatively high interest rates over the past few years (which have only recently been lowered) and improved economic growth prospects, with most banks exceeding earnings expectations.

Johann Scholtz, a senior equity analyst at Morningstar, believes that as interest rates decline, bank profits may stabilize or even decline in the future. Additionally, tariff policies may lead to an increase in corporate bad loan provisions—Royal Bank of Canada pointed out that bad loan provisions in the banking sector had remained stable until now.

Scholtz stated, "We have every reason to expect that tariffs will lead to an increase in corporate default rates."

Morgan Stanley analysts noted that second-quarter earnings data supports the view that net interest income (NII, the difference between loan and investment income and deposit interest expenses) for banks bottomed out earlier than expected, with a recovery in growth anticipated by 2026.

Interest rate cut cycle nearing its end

Even as profit growth momentum weakens, the banking sector will still receive support, as the European Central Bank's interest rate cut process is nearing its end, and the era of negative interest rates has clearly become history.

Morningstar analyst Scholtz stated, "Over the past decade, we have experienced zero and negative interest rates, and the damage caused to European banks has actually been severely underestimated."

A recent study by the European Parliament found that European banks are more sensitive to interest rate changes compared to their American counterparts—net interest income accounts for 60% of their operating net income.

Although interest rates have retreated from a peak of 4%, market expectations suggest that rates will not significantly fall below 2%, as the EU-U.S. tariff agreement has alleviated economic uncertainty.

Shanti Das Wermes, a portfolio manager at MFS Investment, stated, "We are currently almost in a sweet spot: banks can finally profit from their deposit businesses, while there has yet to be pressure on the credit side."

Additionally, market expectations for further interest rate cuts in the UK are limited, which also supports NatWest (NWG.US), Lloyds (LYG.US), and Barclays (BCS.US). So far this year, the stock prices of these three banks have risen between 35% and 50%, but they still remain below pre-2008 financial crisis levels

Sector Differentiation: Winners and Losers

In the STOXX Europe 600 Banks Index, the average price-to-book ratio (a measure of a bank's market value relative to its asset value) has risen to 1.12 times—previously, this ratio had been below 1 for many years. This change indicates that the market is more confident in the banking sector's prospects for creating greater shareholder value.

However, not all banks are performing well. Thanks to merger and acquisition expectations related to Commerzbank (CRZBY.US) and Banco Sabadell (BNDSY.US), banks in Germany and Spain have performed relatively well.

Spain's strong economic vitality supports the banking sector, which is closely tied to the overall economy; Germany's fiscal stimulus policies have improved economic growth prospects, and the country's business confidence index reached a 15-month high in August.

In contrast, UBS (UBS.US) faces multiple challenges: high tariffs in the U.S., a 0% interest rate, and new capital regulation requirements.

Additionally, recent political turmoil in France has led to a sharp decline in bank stocks, highlighting the fragility of market sentiment—Société Générale (SCGLY.US) saw its largest single-day drop since April on Tuesday.

Reduced Risk Levels

Overall, however, investors have lowered their risk assessments for the banking sector. The cost of credit default swaps (CDS), which reflects the cost of default insurance, has been steadily declining.

For example, Deutsche Bank (DB.US) saw its CDS rates briefly exceed 200 basis points during the 2023 U.S. banking crisis that spread to Europe, but it has now fallen to around 54 basis points.

High-risk Additional Tier 1 (AT1) bonds are also showing a robust recovery trend. The 2023 bankruptcy of Credit Suisse raised questions about the viability of AT1 bonds, but the market performance of these bonds has gradually stabilized.

Ian Birrell, Chief Investment Officer at Premier Milton, stated: “AT1 bonds are an excellent combination—they offer high returns and are essentially investment-grade bonds without the investment-grade label.” He also mentioned that the portfolio he manages has a high allocation to the financial sector Analysts point out that European bank stocks have recently reached their highest levels since 2008, and the overall strength of the banking industry is also stronger than in 2008, with significantly reduced leverage.

Is it feasible to buy on dips?

Christian Sole, Deputy Head of European Fundamental Equities at Candriam, holds a neutral stance on the banking sector. He significantly increased his holdings when bank stocks were "extremely undervalued" before the COVID-19 crisis in 2020.

Sole stated, "The current upward momentum of bank stocks is still positive, but the current stock prices do not support our overly optimistic view." He added that while the risk of economic recession is not part of his forecast, the market has not priced it in.

However, some institutions believe that any sell-off presents a buying opportunity. Morgan Stanley suggested this week to "buy on dips" when European bank stocks weaken.