European banks are in solid financial shape, and interest income is exceeding expectations. Still, bank analysts are raising eyebrows at the sector’s sharp rally.
Bank stocks continue to deliver exceptional performance. The Stoxx European Banks Index has surged more than 20 percent since the start of January, following a stellar 26 percent gain in 2024 that made the sector the undisputed leader on European exchanges. Analysts are taken aback. “European banks were due for a revaluation, but the pace of the rally has surprised me,” said Luc Plouvier, senior portfolio manager of Kempen’s European Dividend Strategy.
He attributes the sharp rise in share prices to shifting interest rate expectations. “A year ago, markets expected the ECB’s policy rate to gradually decline to 1.75 percent by 2025—or even lower. That scenario is unfavorable for banks, as profitability comes under pressure when rates fall below 2 percent. Today, investors expect rates to remain well above 2 percent, sparking a relief rally.”
More recently, increased European defense spending and Germany’s massive infrastructure investment plans have also come into focus. “This represents a fundamental shift that will shape ECB policy,” said Plouvier. “Higher public spending raises inflation risks, limiting the central bank’s room to cut rates—or possibly even forcing it to tighten further. That’s positive news for European bank stocks, which were already attractively valued.”
Will credit growth accelerate?
Kempen holds a roughly 3 percent underweight position in banks relative to the MSCI Europe in its European Dividend Strategy. However, when including insurers and financial services firms like asset managers, the sector’s weight aligns with the benchmark. Plouvier is particularly interested in banks that perform well throughout the economic cycle. “These are typically high-quality institutions with strong capital positions that don’t rely solely on interest income but also operate in areas like insurance or private banking.”
Naturally, the dividend-focused team remains disciplined on valuations. Thanks to the sharp rally, Plouvier noted that the sector’s price-to-earnings ratio has climbed from around 7 to 9. “That means European banks are no longer significantly cheaper than U.S. banks, which are trading at 10 times expected earnings. They are still attractively valued in absolute terms, but I’d be surprised if share prices continue rising at this pace.”
So far, sector earnings have risen due to higher rates, but credit growth has remained subdued. Plouvier believes that if demand for loans increases as a result of Europe’s investment plans, bank shares could get another boost. “The flipside is that banks will need to hold more capital to support that credit growth. For now, many European banks are in a stronger capital position than required, which allows them to return relatively large amounts of capital to shareholders.”
The team is not focused solely on high dividend yields. “We continue to find the combination of dividends and share buybacks attractive—especially since repurchase programs often lead to dividend hikes,” said Plouvier. However, with valuations rising, he sees share buybacks becoming less appealing, and suggests that banks might increasingly turn to acquisitions. “We’re already seeing activity pick up in Spain and Italy, although cross-border mergers remain challenging due to a lack of synergies.”
Taking profits on AT1 bonds
Joost Beaumont, head of Bank Research at ABN Amro, is also surprised by the strength of the European bank rally. “Bank stocks were attractively priced, trading well below book value. But the degree of outperformance is striking.” Still, he believes the catch-up is justified. “From a top-down perspective, European banks have become far more resilient thanks to stricter regulation. Non-performing loans have fallen to historic lows, and interest income is beating expectations.”
Beaumont noted that investors have a very bullish outlook on European banks, which is also evident in the bond market. Among all bank bonds, the riskiest AT1 securities have delivered the strongest returns in recent years. “That’s remarkable, given how recently we had the Credit Suisse AT1 debacle, where those bonds were unexpectedly written down following the UBS merger in 2023.”
“We had an overweight in AT1 bonds, but took profits a few weeks ago,” said Beaumont. “With the threat of a full-blown trade war, we are moving toward a worst-case scenario where the U.S. enters a recession and inflation remains high. That would be a nightmare for financial markets and could trigger a deeper correction. In that case, credit spreads on bank bonds would widen significantly.” He noted this trend has already begun since late February.
According to Beaumont, the risks in AT1 bonds are now too high, and it is better to wait in cash or safer bonds to assess how the situation develops. “If things turn out better than expected, you can re-enter—perhaps missing some returns, but with less risk.” In effect, it’s a veiled sell recommendation for bank stocks, as AT1 bonds carry similar risk profiles.
Still, Beaumont remained positive on the earnings outlook for European banks. “We believe the ECB will cut rates further than the market anticipates, while long-term rates will decline more gradually. A steeper yield curve is favorable for bank profits. Yes, banks may need to add to their loan loss provisions if the economy weakens due to import tariffs, but their profitability should remain robust.”