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Once upon a time, in a collective mess, the countries of Portugal, Ireland, Italy, Greece and Spain were known by the unflattering acronym of Piigs. Too much government debt and bad loans in their banking systems then threatened the future of the euro.
Now, after a lengthy state backed clean-up, the tables have turned. At least in banking, Europe’s periphery may be in better shape than its core. Banks that were once deemed untouchable by investors are suddenly back in vogue.
The attraction is a combination of low valuations, better economic growth and higher sensitivity to interest rates. These factors have driven outperformance. Total returns for bank sectors indices in all five countries are at least 100 per cent since 2022. Comparable gains for all Eurozone banks are only 60 per cent. Investors are starting to entertain the once unimaginable, that the days of low single-digit returns on equity in European banking are mostly a thing of the past.
True, periphery banks tend to outperform when interest rates are rising thanks to a higher share of variable rate loans. Average returns on tangible equity have been 13 per cent in Italy and Spain in 2022 and 2023 compared with 9 per cent in France and Germany. Periphery banks have also passed rates on to savers more slowly, helping bolster margins.
They are not getting much credit in their valuations, however. Share prices have risen for most European banks but they have still lagged well behind profit growth. Forward earnings multiples between six and seven times remain near crisis-era levels. That is in spite of returns on tangible equity that are expected to remain elevated until the end of 2026 at least.
As interest rates start to fall, returns at German and French banks should rise: interest margins usually benefit at that point in the cycle from higher fixed rate loans already on the books and falling deposit rates.
But this may also be the point that cleaner loan books in the periphery come into their own. Government support has helped keep loan losses low across Europe since 2020. That could change faster in northern europe amid weaker economic growth, higher private sector debt levels and rumblings of distress in commercial real estate markets. Years of tighter lending standards and lower debt demand may keep a lid on loan losses in a slowdown, argues Jason Napier at UBS.
That may be one reason to take a contrarian view: even as rates begin to fall, the lowly rated banks in Europe’s periphery may continue to fly.
