European banks perform in Q1

European Banks generally enjoyed their best earnings season in a long time. Their first quarter performance was again very positive with broad-based beats across the sector. Aggregate pre-tax profit was 36 per cent ahead of consensus expectations, resulting in bank related risk assets outperforming general indices.

The main profit drivers were significantly lower than expected loan losses and positive fee income performance, similar to the performance in 4Q2020. Importantly, these two tailwinds are expected to remain in effect this year and help to offset ongoing interest rate headwinds that remain a drag on profitability.

The reduction in loan loss provisions originated as a result of greater confidence into forecasts and asset quality in particular. Additionally, the anticipation of rising capital return should support banks over the next six months. This general backdrop should prove to be beneficial to both equity and fixed income investors throughout 2021.

The performance of banks was helped by positive jaws, being wider operating margins. A general mild increase in costs was more than offset by improved revenue performance, originating from fee income as well as investment banking.

Net interest income remained in decline, as higher yielding corporates continue to refinance at lower rates lowering the average yield on bank’s loan book. Unless interest rates trend materially upwards, this situation expected to continue to be a secular issue in the developed economies.

In a reaction to this secular reality, banks are well into the redefinition of their strategy, with a main focus that has shifted to fee income. Indeed fee income growth momentum continued in the first quarter, mainly driven retail brokerage and asset management.

The European Central Banks green lighted the resumption of dividends back in December. Despite this, a stronger than expected performance resulted in better capital ratios across a majority of banks, which was also aided by lower risk-weighted assets.

The financial sector remains a core holding in our model portfolios in for both fixed income and equity asset classes. In the fixed income space, this applies to subordinated debt where pockets of relative value remain, albeit increasingly difficult to identify.

In the equity space, the sector remains undervalued from a relative valuation perspective, as consensus remains unambitiously moderate in terms of earnings growth potential, keeping multiples at low levels despite the steep recovery in prices since the depths of the pandemic.

Banks’ valuations are currently being conditioned by the recent increases in stage 2 loans. As more visibility on their evolution unfolds over the coming quarters. This remains a key risk to the sector as the threat of banks having to provide for any credit events remains due to the scarring to a number of sectors as a result of the pandemic, notably in the travel and retail segment.

In our opinion dividend opportunities from strong European banks rival the increasingly narrow spreads obtained from even the lowliest ranked credits, with the added benefit of capital growth potential upon further normalisation.

When considering the persistently high levels of liquidity in the market, this adds a technical element to the rationale. Along with the positive catalysts for the banking sector on a standalone basis, it gives us reason to retain exposure to the financial sector over the course of the year.