By Naomi Rovnick
LONDON (Reuters) - Storm clouds are brewing over European banking stocks as the boost from higher interest rates fades and recession risks rise, yet bank valuations are still weighed down by too much caution, investors said.
On the surface, Europe's volatile bank shares have had a good year, up almost 16% in 2023 versus a 7% rally in the broader STOXX share index. Still, some big investors in the sector are convinced it remains lowly valued.
Just before earnings season kicks off, European bank shares are sporting a dividend yield of almost 8%, making them cheaper on this basis than during the 2008 global financial crisis.
Banks' extreme sensitivity to macro-economic conditions makes the sector an easy one to avoid. But the per-share cost of receiving banks' dividends at current inflation-busting rates is probably too low, investors said.
"You're being paid quite handsomely to wait for what's coming in the economy over the next two years," said Guy de Blonay, investment manager at Jupiter Asset Management, who is adding to his positions in European banks.
Sebastiano Pirro, chief investment officer at Algebris Investments, said European banking shares were too cheap considering these lenders hold chunkier capital buffers to cover future losses than regulators require.
"Despite (a) meaningful improvement in profitability, continued earnings upgrades and solid fundamentals, these stocks remain cheap," he said.
TOO LOW?
As the European Central Bank pledges to keep interest rates around their current record high, threatening a vicious cycle of debt defaults and collapsing asset values, banking shares are still taking the hit of credit cycle fears, analysts and investors said.
European bank stocks are trading at around six times forecast earnings - less than half the level of the Stoxx 600 index overall, indicating that investors fear lenders' profits getting crushed by bad debts.
The sector is also valued, on a price-to-book basis, at less than 70% of banks' own assessments of what their assets are worth.
The market "believes there will be credit issues" said Roger Lee, head of UK equity strategy at Investec, who added the fears were overdone and that made bank shares "too cheap."
European banks, which struggled during 2014 to 2022 as the ECB kept rates below zero, have had a major boost from hiking their loan costs in line with central bank rates.
Analyst forecasts collated by European asset manager Amundi show European banks are expected to grow adjusted earnings per share by 25% this year, followed by a 6% gain in 2024.
The European financial sector overall is seen recording the highest earnings growth rate of every industry category in the region, at just over 20%. It is expected to earn almost 40 billion euros in the third quarter, versus almost 33 billion euros in the third quarter of 2022, according to LSEG I/B/E/S.
Bank profits are currently "at the top of the cycle," said Michele Morganti, senior equity strategist at Generali (BIT:GASI) Investments.
But he added that this growth slowdown would not be sharp enough to prompt lenders to cancel their dividends in the absence of a "real, massive credit event."
After a coronavirus crisis ban on bank dividends in 2020, these payouts are back.
Italy's Unicredit (BIT:CRDI) has pledged to return 5.25 billion euros to shareholders. Banks are now the biggest driver of dividend growth in the UK, Computershare estimates show.
The International Monetary Fund has warned that 5% of global lenders are vulnerable from higher for longer rates.
"There will be knives that fall," Algebris' Pirro said, while pointing out that it still made "a lot of sense to own large-cap institutions."
Generali's Morganti said he has moved his position on European banks from negative to neutral and was likely to add more. He did not forecast quick gains for European banks ahead, however.
"The market is waiting to see how much downside risk there is from an economic slowdown," he said. "This could take a while."