This article was originally published in The Sunday Times

Eurozone banks reach record high capitalisation levels

Since 2007 the stock market has significantly de-rated the banking sector leaving the Euro Zone banking sector at relatively low valuations compared to the broader Eurozone stock market. The Banking sector in the Euro Zone is now one of the cheapest sectors of the Eurozone stock market.

Higher interest rates in recent years have also significantly improved bank operating margins. Eurozone banks capital generation continues to be strong.

The European Banking Authority (EBA) in its Q4 2023 quarterly Risk Dashboard (RDB) issued earlier this month, reported that EU/EEA banks reached record high capitalisation levels, with the weighted average common equity tier 1 (CET1) ratio (fully loaded) at 15.9%, 50 bps higher than in December 2022.

Banks can also offer growth opportunities, as the economy expands, demand for loans and other financial services typically increases, leading to potential growth in banks’ revenue and profitability.

Eurozone Banks are outperforming US peers

According to analysts at Barclays, the Eurozone’s banks are outperforming their US peers for the first time in more than a decade in return on equity terms. “European bank fundamentals look stronger than ever,” said the bank’s head of European equity strategy Emmanuel Cau.

Despite their strong recent performance, European banks are still heavily undervalued compared to their US peers, which have grown faster and been more profitable since the financial crisis.

To address this valuation gap and to regain investor confidence, which had been affected by measures such as dividend bans and windfall taxes implemented since the pandemic, European lenders have promised to return more than €120bn to shareholders this year, through €74bn of dividends and €47bn of share repurchases. This is a 54 per cent increase on the previous year’s capital returns and far higher than every year since at least 2007, according to figures compiled by UBS.

This strategy is being implemented by many lenders as they bolster their stock prices and reassure shareholders of their long-term viability and profitability prospects.

Allied Irish Bank this week announced an EGM on the 02/05/2024 to hold a vote on a proposed contract for the off-market purchase by the Company of ordinary shares from the Minister for Finance (the “Minister”) for a total consideration of €999 million (being €1 billion less expected costs). At the current price this represents 201.7m shares (7.7% of outstanding shares) and will reduce the Irish Government’s holding to 32.27% from 38.97% as of March. AIB intends to cancel the Ordinary Shares which are purchased.

UniCredit, whose shares have more than doubled over the past year has promised to return €8.6bn, its entire profit for 2023, to investors.

As core European banks increasingly return surplus capital via increasing dividends and share buybacks and continue to show resilient earnings, while costs remain under control, we would expect the valuations in the Euro Zone banking sector to improve over future years. The Eurozone banking sectors very low valuations, free cash flow generation plus excess capital may provide some downside protection and rebound potential for the sector in future years.

EURO STOXX BANKS Index returns an impressive 19% YTD

The EURO STOXX BANKS Index (SX7E Index) (The Index) is a stock market index that tracks the performance of 25 of the largest Euro Zone bank stocks. The Index is often used as a benchmark to gauge the overall performance of the European banking sector.

It should come as no surprise to hear that it has returned 37% in the last 12 months and almost 19% year to date.

The strong performance of the Euro Stoxx Banks index coincides with impressive fourth-quarter results from major European lenders like UniCredit, Santander, and Lloyds Banking Group, confirming a positive trend in the banking sector.

The notable uptick in share prices for Italian banks UniCredit and Intesa Sanpaolo to multi-year highs underscores growing investor optimism towards the Italian banking sector. This surge in share value suggests that investors perceive these banks as well-positioned to navigate through economic uncertainties and capitalize on potential growth opportunities.

The strong performance of Allied Irish Bank and Bank of Ireland, both constituents of the Euro Stoxx Banks Index, with gains of 30% and 20% respectively year to date, indicates positive sentiment towards these Irish banks within the European banking sector.

Investors are optimistic about the prospects of Allied Irish Bank and Bank of Ireland due to various factors such as improved financial performance, effective management strategies and favourable economic conditions.

An opportunity for investors

Overall, the performance of these European lenders and the broader Euro Stoxx index reflects a positive sentiment in the market regarding the banking sector’s ability to weather challenges and capitalize on emerging opportunities, thereby contributing to the overall bullish market sentiment.

European Banks are trading at around 75% of their book values, and at a relatively low-price earnings (p/e) ratio of around 6 times 2024 earnings estimates on average. Whilst the broader Euro Zone stock market currently trades at over 13 times earnings and circa 180% of book value. Historically, European banks have traded at an average 9.4 times consensus forward earnings per share since 2003 but are now trading at just 6.3 times earnings estimates.

Investing in the Euro Stoxx Banks Index through the Euro Stoxx Banks UCITs ETF [EXX1-XEX] provides investors with exposure to a diversified portfolio of European banking stocks. Even after the latest steep gains, Europe’s banks are still cheap versus history. The subindex trades at 7.3 times earnings expected 12 months from now versus a multiple of 10 in the early part of 2022.

The trailing one-year yield of 4.72% makes it attractive to income-oriented investors seeking dividends. This yield represents the total dividends paid out by the ETF’s holdings over the past twelve months relative to its current price and is paid out quarterly.

A higher yield can be appealing, but investors should also consider factors such as the sustainability of dividends and the overall performance of the ETF over time.