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Once upon a time, Portugal, Ireland, Italy, Greece and Spain were in a state of collective chaos, known by the unflattering acronym “Piigs”. Excessive national debt and bad loans in their banking systems threatened the future of the euro.
After a lengthy, state-supported restructuring, the tide has now turned. At least in the banking sector, the peripheral European countries may be doing better than the core. Banks that were once considered untouchable by investors are suddenly back in fashion.
The appeal lies in a combination of low valuations, better economic growth and higher interest rate sensitivity. These factors have led to outperformance. Total returns on banking sector indices in all five countries have been at least 100 percent since 2022. Comparable earnings across all eurozone banks are only 60 percent. Investors are beginning to grapple with what was once unimaginable: that the days of low single-digit returns on equity in European banking are largely a thing of the past.
Peripheral banks tend to perform better when interest rates rise due to a higher proportion of variable-rate loans. The average return on equity was 13 percent in Italy and Spain in 2022 and 2023, compared to 9 percent in France and Germany. Peripheral banks have also been slower to pass on interest rates to savers, which contributes to higher margins.
However, their valuations do not give them much credit. While share prices of most European banks have risen, they are still lagging far behind earnings growth. Expected earnings multiples of between six and seven times remain close to crisis-era levels. And this despite returns on tangible equity expected to remain high at least until the end of 2026.
As interest rates fall, German and French banks’ yields are likely to rise: interest margins at this point in the cycle typically benefit from higher fixed-rate loans already on the books and falling deposit rates.
But this could also be the point where cleaner loan books in the peripheral countries come into play. Government support has helped keep loan losses low across Europe since 2020. That could change more quickly in northern Europe, given weaker economic growth, higher private sector debt and signs of trouble in commercial real estate markets. Years of tighter lending standards and lower demand for credit could keep loan losses in check in a recession, argues Jason Napier of UBS.
This could be a reason to take a contrarian stance: even if interest rates start to fall, the low-rated banks in the European peripheral countries could continue to soar.
