Strong balance sheets, low valuations and an expected profit boost from rising interest rates make European banks an attractive investment bet despite recent price volatility, portfolio managers and analysts said.

Banks' healthy capital levels and liquidity mean they are well prepared for any increase in loan losses due to an economic slowdown, high inflation and geopolitical uncertainty, experts said.

"We remain overweight on financials and specifically on European banks," said James Beaumont, head of multi-asset portfolio management at Natixis Investment Managers, in an interview. "We think there's some value in where banks are priced now versus other parts of the market."

Its double overweight position on the European financial sector, and banks in particular, was Natixis IM's best trade in 2021. It lowered the position to single overweight in 2022 but still sees value in the trade. It will "continue to hold the position in the long term," Beaumont said.

European bank stocks have been on a rollercoaster ride since the start of the Ukraine war on February 24. The stocks booked a 14.08% drop in total return at the end of June, having been among the best performers in January and early February, S&P Global Market Intelligence data shows.

Two weeks before the war, the STOXX Europe 600 Banks index hit its highest value in more than three years. Since then has lost more than a quarter of that value. In 2021 the index gained 34.04%, outperforming most other sectors and the wider STOXX Europe 600 index, which rose 22.87% over the same period, the data shows.

Rate hikes

A key driver behind Natixis IM's conviction in the European banking sector is the expectation for tighter monetary policy in 2022 and beyond. "The ECB has been behind the curve on raising rates and will try and catch up [now]. In the short term at least, that's going to be positive for European banks and financials in general," Beaumont said.

The biggest boost for banks will come when the key deposit rate turns positive. When this happens the sector will be able to make money from deposits for the first time in years, Johann Scholtz, senior credit analyst at Dutch asset management firm Actiam, said in an interview.

Traditional retail banks with large deposit franchises will benefit most, but the rate hikes will boost the entire banking sector as net interest margins will improve overall profitability, Scholtz said.

The general consensus is that the average return on equity of the European banking sector when interest rates return to positive territory would move to a low double-digit level of 11% or 12% from the mid-single digit range recorded in recent years, Scholtz said.

The return on average equity of the 15 largest European banks by market capitalization stood at 8.6% in the first quarter of 2022, according to S&P Global Market Intelligence data.

The ECB has said it would end its long-standing negative rate policy in 2022, starting with a rate hike to minus 0.25% at its July 21 meeting. There will be another increase in September, which is expected bring the deposit rate above zero for the first time in more than eight years. The deposit rate moved into negative territory in June 2014 and has been at negative 0.5% since September 2019.

Healthy position

Higher interest rates are good news for bank stocks, but the economic downturn is a key downside risk given concerns of deteriorating asset quality and potential surge in loan losses. Yet European banks still offer an attractive risk/return trade-off despite the cyclical and geopolitical uncertainty, Vincent Vinatier, portfolio manager at AXA Investment Managers, said in a written comment.

Banks balance sheets are much healthier now, having undergone significant de-risking in the 14 years since the global financial crisis. Capital and liquidity ratios are "incomparably stronger" after years of capital build-up and shedding of nonperforming loans, Vinatier noted.

European banks' weighted average nonperforming loan ratio, which measures the amount of soured loans to total outstanding loans, declined to 1.9% in the first quarter of 2022 from 6.5% in the fourth quarter of 2014, the latest data from the European Banking Authority shows.

While the economic slowdown could result in higher credit costs for European banks, the sector still has plenty of unused loan loss provisions that have piled up over the last two years as most of the banks performed better than expected during the COVID-19 pandemic, Vinatier noted.

European banks are able to absorb nearly three times the loan losses recorded in the pandemic year 2020 before running short of capital relative to management targets, UBS analysts estimated in a July 6 research note, using a sample of 44 large European banks.

Dividend outlook

Another boon for bank stocks is the positive outlook for dividend payments and share buybacks, which are expected to continue in 2022, despite ECB board chair Andrea Enria's recent warning that the supervisor will consider recession risk before approving bank dividend proposals.

A EU-wide dividend ban like the one imposed at the start of the pandemic in 2020 is not anticipated, UBS analysts said. Share dilution and dividend bans are not an appropriate base case scenario for the banking sector because of banks' balance sheet strength, they noted.

Banks have large excess capital buffers and have already been introducing greater flexibility in their capital return policies by cutting dividend payout ratios and increasing the number of ad-hoc share buybacks, Scholtz said. This is a "prudent way" to approach distributions in the current uncertainty and is in line with the messaging from the ECB, he said. "From what I understand, the regulator is not that keen on implementing another ban on dividends or share buybacks," Scholtz added.

The resumption of distributions was a big driver behind the bank stocks' growth in 2021 after the previous year's dividend ban.

"European bank regulators seem comfortable that banks' balance sheets are sufficiently strong and that a deterioration in the credit cycle will not lead to forced recapitalizations and equity dilution," AXA IM's Vinatier said.