What’s next for the banking sector as rate cuts loom?

After a long wait, interest rate cuts are starting to come through. In June, the European Central Bank finally cut rates, alongside the central bank of Canada. The recent US CPI data has left the Federal Reserve still hopeful of a rate cut by the end of the year, while the Bank of England may cut rates in August having seen inflation dip to its target of 2%.

These cuts are neither as soon, nor as extensive, as many economists believed – or financial markets hoped. The delay on rate cuts has been good news for the banking sector, which has sustained its recent strong run. Over the past 12 months, the MSCI Europe Banks Index has risen 29.7%, compared with a rise of just 13.7% for MSCI Europe*. The MSCI World Banks Index has also shown strength, up 31.4% over the past year, compared with 20.7% for the MSCI World*.

An overview of the European banking sector

However, the recent performance of the banking sector may signal tougher times ahead. The MSCI Europe Banks sector has dropped 4.7% versus a fall of 1.0% for the wider market this month*. European banks have been weaker than their global peers, and this has had two main drivers: rates cuts by the ECB appear to have derailed a nascent recovery in the sector, and the uncertainty over the French election has also been a destabilising factor.

In France, the banks have been seen as a proxy for the broader French economy. There were concerns that political uncertainty could bring about increased economic risks to an already fragile situation. The country’s banks may face higher funding costs if international markets raise the yield on French debt. The yield on French sovereign bonds has spiked higher over benchmark German bonds since the election was announced on 10 June.

Rob Burnett, manager on the WS Lightman European fund believes the situation in sovereign bonds is important, saying he is focusing the fund’s exposure on “those banks that are well capitalised, have strong lending standards and operate in countries with the strongest sovereign credit ratings. Our banks have outperformed in this recent widening of sovereign bond spreads.” His bank exposure is concentrated on countries such as Norway, Denmark and Sweden.

Nevertheless, some fund managers are more positive on the sector. For example, Niall Gallagher, manager of the GAM Star Continental European Equity fund has held a significant overweight exposure to European banks for three years and maintains its view that the sector is attractively valued:

“For most of last year the European banking sector was trading at some of the lowest valuations in stock market history.” He points out the PE multiple and Price Earnings Relative suggest that there is somewhere between 35-50% upside to get to either an average valuation multiple, or to establish a normal relationship with the rest of the market – “on that basis, the sector remains cheap in valuation terms,” he adds.

He is less fearful on the impact of falling interest rates. He says that the rise in central bank interest rates has been transformational to the profitability of European banks, leading to a more than doubling of the sector’s return on equity, but, “ultra-low or zero interest rates/yields are very negative for bank earnings and return on equity but otherwise interest rates and yields really do not matter much at all, with competitive intensity far more significant.”

His view is that the sector has deleveraged, while also going through significant consolidation. The sector has also embraced share buybacks and has a competitive dividend yield (6.2% for the MSCI Europe Banks)*.

Are UK banks any different?

Many of the same factors are driving the UK banks, with many of the UK equity income funds holding a significant weight. HSBC Holdings, Barclays and NatWest Group are three of the top four holdings in the Schroder Income fund**, for example, while Artemis Income fund manager Adrian Frost is also a supporter. He says: “We added to our position in Barclays, given its announcement of what looks to be a credible plan to re-focus the business and create significant shareholder value over the medium term. This was supported by a strong meeting with management. Like Lloyds and NatWest, Barclays has the potential to generate double-digit shareholder returns through a combination of dividends and share buybacks for several years.”

What about US banks?

The US banks are a more complicated option. The market is more fragmented and competitive, and has recently been subject to increased regulation. The failure of Silicon Valley Bank in early 2023 showed the fragility in some parts of the market and a number of banks still have significant unrealised losses in their bond portfolios***. A fall in yields would help, but the US continues to defer rate cuts. That said, a soft landing for the US economy will ease some of the concerns on bad loans.

Guy de Blonay, manager of the Jupiter Financial Opportunities fund continues to prefer banks in Europe and selected emerging markets. His largest three overweight positions were Intesa SanPaolo, UniCredit and Banco do Brasil, while remaining underweight Wells Fargo, JP Morgan Chase, the Royal Bank of Canada and the Commonwealth Bank of Australia^.

The message appears to be that it is not simply marginal shifts in interest rates that are likely to make the difference for banks in this environment. As long as interest rates remain at or near their current levels, banks can still make progress and they pay nice dividends in the interim. However, it remains a sector full of complexity, with significant regional nuances, and is best left to a skilled fund manager to navigate.

*Source: MSCI index factsheet, 28 June 2024

**Source: fund factsheet, 30 June 2024

***Source: Jupiter, 27 November 2023

^Source: quarterly investment report, March 2024