Unicredit UCG kicks off the second quarter (Q2) earning season for the big eurozone banks on July 23. This will be followed by BNP Paribas BNP, Banco Santander SAN, and Deutsche Bank DBK on July 24. Between the end of the month and the beginning of August, Intesa Sanpaolo ISP, BBVA BBVA, ING Group INGA and ABN Amro ABN will present their mid-year results (see table).
Eurozone banking stocks ended the first half of the year up 21.17 percent (Morningstar Eurozone Large-Mid Banks index), doing significantly better than the Morningstar Eurozone index, which tracks the performance of eurozone markets and gained 7.8 percent over the same period.
The banking stocks that contributed most to first-half performance were Italy's Unicredit and Intesa Sanpaolo, which gained 48.3 percent and 36.9 percent, respectively.
Will European Banks Continue to Outperform the Market?
Much depends on how the round of corporate results that will be published in the next few days will go.
“We expect a strong quarter from those eurozone banks with strong debt underwriting businesses like BNP Paribas and Deutsche Bank,” said Johann Scholtz, senior equity analyst at Morningstar, in a note on July 19. “Results from the US bulge bracket investment banks confirm that companies are back in the debt market to refinance. Also, we expect trading revenue to rise due to French election volatility.”
How Will Lower Interest Rates Affect Bank Stocks?
After June’s initial rate cut, the European Central Bank left interest rates unchanged at its July 18 meeting, but markets assign an 80% likelihood that the bank will cut rates by another 0.25 percentage points at its next meeting on September 12. Lower interest rates could weigh on interest margins.
“First quarter 2024 results confirmed that the higher interest rate bonanza is over and that net interest margins for most Eurozone banks have peaked,” said Scholtz. “That said, we do not anticipate net interest margins to narrow materially. Interest rate swap rates are slightly higher for the second quarter than the first, delaying the transmission of lower policy rates. Switching into term deposits from overnight deposits has slowed, lowering margin pressure.”
Main Sources of Revenue for European Banks
Sonja Forster, Senior Vice President European Financial Institutions at Morningstar DBRS, expects solid profits that are driven by higher fee/non-interest income and relatively low credit costs in the second quarter and beyond. Meanwhile, net interest income (NII) will likely display varying performance by geography but remain at relatively elevated levels, she said.
“We expect better non-interest income mostly driven by strong capital markets, which supports revenues in areas such as investment banking, asset management, brokerage activities and insurance,” said Forster in a comment for Morningstar on July 19. “A gradual improvement in economic activity and pickup in lending volumes also drives fee income through higher transaction fees.”
“NII development is expected to benefit from gradually increasing loan demand, but the net interest margin (NIM) development will be more mixed by country, albeit at a high level,” she added.
“Banks in the Nordics and the Netherlands have passed on a large part of interest rate hikes to their customers and are experiencing NIM pressure, partly offset by gradually increasing loan volumes. Southern European banks have been able to pass on significantly less of the rate hikes, so NII is expected to remain strong. Despite the higher proportion of variable rate loans in these countries, we do not expect a major impact from the first rate cut. And subsequent cuts are not expected to be fully reflected in NII due to hedging.”
Risks for Banks Are Receding
“Lower spreads on European high-yield bonds show that the credit market is taking a more benign view of corporate default risk”, said Scholtz, adding that “with unemployment at record lows in most of the eurozone, we do not believe household credit quality will deteriorate.
Regarding costs, banking income statements do not reflect the full impact of negotiated salary increases. However, the Morningstar analyst expects that regulatory costs will decline, because the ramp-up phase of contributions to the Single Resolution Fund - the emergency fund that can be called upon in times of crisis - is now complete.
Strong Asset Quality with Some Pockets of Weakness
Analyst expect that asset quality will remain strong for banks in most countries with some pockets of weakness, especially in commercial real estate, construction, retail and consumer finance.
“We do not expect the small cut in policy rates to have a major impact on asset quality. Not only because the cut has been relatively small, but also because the rate increases have, with the exception of certain sectors, had a limited effect so far, helped by low unemployment and prudent loan underwriting”, said Forster. “However, adverse effects from higher rates could still materialize over the medium term, especially in countries with a high proportion of variable rate loans. We therefore expect that further gradual rate cuts will lower the risk of deteriorating asset quality.”
Eurozone Banks Offer Attractive Dividends and Buybacks
One factor that makes banking stocks attractive are buyback plans. “They are returning large amounts of capital to shareholders without compromising their businesses,” Lazard Asset Management analysts wrote in a July 17 report on opportunities in the sector.
“European banks now generate more free cash, supporting generous dividend payouts and share buybacks,” according to Morningstar's Scholtz. “The improvement in free cash flow is due to higher profitability and limited additional capital requirements.”
Unicredit and Intesa on the Radar
Many investors are focusing on mid-year earnings of Italian banks, like Unicredit and Intesa Sanpaolo, after the stocks outperformed peers in the first half of 2024.
Morningstar DBRS expects Italian banks’ Q2 results to confirm solid performance despite some slowdown in net interest income (NII) mainly resulting from the rate cut, lower loan volumes and higher funding costs, as well as potentially higher loan loss provisions (LLPs) reflecting some asset quality deterioration.
“Our view is that NII should remain robust in Q2 2024 as average commercial spreads will likely remain higher than in the corresponding period in 2023. In addition, good trends in net fee and commission income as well as cost control should help mitigate the negative impact from NII,” said Andrea Costanzo, Vice President European Financial Institutions at Morningstar DBRS.
“Some higher new non-performing exposure (NPE) inflows due to still-high interest rates and slowdown in economic activity are likely to materialise. This, coupled with weaker new loan origination in recent times, might lead to a deterioration in asset quality metrics. However, at this stage Morningstar DBRS expects default rates to generally remain at relatively low levels, below the level of default rates experienced in the global financial crisis,” he added.
“All-in-all, banks should be able to preserve good capital cushions against their supervisory minimum requirements. At the same time, Morningstar DBRS expects Italian banks to have continued to reimburse the ECB’s TLTRO III sources-- the Eurosystem operations that provide financing to credit institutions-- according to plan, leading to a further normalisation of the previously very ample liquidity levels.”
High Public Debt a Headwind for Italian Banks
The Italian banking system remains more exposed to market volatility than its European peers because of Italy's high public debt that weighs on sovereign creditworthiness. According to the latest Bank of Italy data, public debt rose to EUR2.919 trillion in May, up 13.3 billion euros from the previous month and inching closer to the 3 trillion mark.
June demonstrated this vulnerability as BTP-Bund spreads widened after European elections and the French parliamentary election.
European Banks Can Still Rise
Europe's bank sector is very close to the year's highs, having recovered most of the losses that followed the first round of France's elections-- still, investors’ views remain constructive.
“We still see potential for further multiple expansions in the mid-term and we are optimistic on the upcoming earnings season, although we assume that the recent performance and the expectation of further decline in rates ahead will test tolerance for any NII disappointments or ‘low quality beat’," said Luca Finà, Head of Active Equity at Generali Asset Management.
“With the peak in rates behind us and earnings momentum losing steam compared to the last couple of years, all eyes will be on the net Interest Income line and on the capacity of fees to offset the P&L effects of rates reduction, above all in the Southern Europe,” he added.
In a July 19 note for Morningstar, Justin Bisseker, European Large Cap analyst at Schroders, said they shouldn’t expect many surprises in the second quarter, “as falling rates have only just started to take effect and analysts have already factored in lower rates in their forecasts.”
He added that they anticipate a strong quarter for the investment banking income segment, although less pronounced than in US. Also, fee income trends may exceed expectations, “suggesting we are more likely to see revenue surpass forecasts rather than fall short”.
“Overall, European banks have seen a significant boost in profitability over recent years, driven by higher rates. Barring an unexpected sharp decline in rates or steep recession, this positive trajectory appears set to continue,” Bisseker added.
