Rising rates – a game changer for banking stocks?

A long-awaited rise in rates

European banks have spent years toiling under negative interest rates, meaning revenues have gone nowhere for almost a decade, despite some 3% annual growth in loans. This has now started to change. In the second quarter (Q2), European banks posted revenue growth of 8%, driven by a 14% increase in net interest income. As earnings momentum improves, so do analysts’ expectations of future profits.

For US banks, which are further along in the economic cycle, the picture is also positive, albeit more nuanced. US interest rates went up earlier, meaning the marginal benefit of further hikes is now less, and banks are closer to ‘peak’ earnings. The pressure on deposit rates is also higher across the Atlantic as customers move deposits to higher-yielding opportunities. Meanwhile, cost inflation is stronger and the Federal Reserve stopped quantitative easing earlier. Yet US banks still posted 4% revenue growth in Q2, even if lower income from fees tempered higher net interest income.

Of course, many banks combine deposit taking and loans with other activities, e.g. for wealthy individuals, large investors and companies. For those with sizeable investment banking businesses, market volatility and uncertainty have badly dented fees from debt and equity issuance, initial public offerings (IPOs), mergers & acquisitions – although on the latter, pipeline deals are reportedly high. This tough environment will likely result in staff cuts. In Europe, market volatility has also exposed vulnerabilities in some individual stocks, where the probability of capital increases has risen.

Recession risks rising

The risk hanging over all banks is the looming threat of recession. The flipside of rising interest rates is that they typically end in a downturn, and we foresee a 2023 recession in both the US and Europe. As more individuals and companies struggle to meet loan repayments, banks see loan growth dry up, and have to increase provisions to cover possible defaults. On both sides of the Atlantic, asset quality is close to its best, with few signs of stress, but we expect the cost of risk to go up in 2022 as banks revise their macroeconomic scenarios downwards.

Still, the starting position for many as we enter this recession looks strong. Balance sheets were cleaned up after the global financial crisis (GFC) of 2007-2008, and non-performing loans sold – nowadays, we believe risks are just as likely to lie outside the banking sector. Capital levels at the majority of European banks look more than adequate today; some are even trying to return excess capital to shareholders. Unlike the events that caused the GFC, recessions that follow rising rates are at least a known risk for which banks can plan and prepare.

Such preparations are already well underway. New accounting rules mean that European banks are booking loan loss provisions as they revise their economic scenarios. Many also have significant Covid-19 loan provisions which could now be repurposed, giving an additional risk buffer (in the US, these have largely been released). Most banks believe that the additional revenues they make from higher rates should more than compensate for the increase in costs due to inflation and higher provisions.

In all, better balance sheets and rising rates should prove a significant help in dealing with the downturn. Government support to combat the impact of high energy costs also provides some comfort on households’ and corporates’ ability to meet loan payments, while some banks in Europe still benefit from state-backed loans granted during the pandemic. In meetings with management teams – especially in Europe – our analysts report buoyant sentiment.

Risks – recession, one-off taxes and the ECB

Of course, both banks’ and analysts’ estimates on the scale of the downturn may prove too optimistic. A severe downturn could also bring swifter than expected rate cuts, taking away banks’ profitability uplift in short order. Big ‘tail’ risks also rise in downturns, amid particularly unpredictable and volatile markets – one example being the recent historic movements in UK gilts.

Meanwhile, geopolitical risks remain, as do political concerns closer to home. Banks look set to report strong earnings at a time when most of the economy will be suffering badly. Governments might view these as ‘excess’ profits and seek to appropriate some through bank taxes and levies. While we believe the case here is harder to make than for energy companies – where windfall taxes have already been imposed – levies on banks have now been mooted in Spain and the Czech Republic.

Another worry relates to possible changes in the way the European Central Bank (ECB) treats reserves from commercial banks (quantitative easing resulted in lots of these deposits), and loans it extended to them. Earlier this month, the ECB changed its treatment of the former, meaning banks now earn the headline interest rate on their deposits. As rates rise, interest earned could prove politically problematic and be seen as a public subsidy for banks. The Swiss National Bank has recently taken a tougher line here, setting a precedent that the ECB may be forced to emulate.

Are banking stocks due an upgrade?

Despite these risks, we believe many banks are on a strong fundamental footing, and rising rates should provide a significant tailwind for earnings this year and next. Yet investors have yet to be convinced of their merits, even if analysts are. Following years of scepticism on investment returns, valuations currently look very attractive, being well below historical averages, in terms of both price/tangible book and price/earnings metrics.

True, investing in banks – especially European ones – has often been unrewarding. Outperformance versus the broader Euro STOXX 50 index has been rare in the past decade (2021 being a notable exception). Absolute performance of US banks has been better, but versus the S&P500 also uninspiring, due largely to outsized returns from tech stocks in recent years.

So far this year, significant earnings revisions for European banks have not led to an uplift in share prices. If anything the reverse has been true, a disconnect and de-rating we see as a potential opportunity. While recession risks and the potential for windfall-type taxes mean we keep a neutral view on the sector, we would certainly highlight the case for some strong and diversified banks at these levels. We retain our preference for those with sound balance sheets, strong capital levels and the potential for capital return – the latter more likely to be found in Europe than in the US.

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