- European banks have been one the best performing sectors posting a 18% return YTD (8% for the STOXX)
- Limited upside in earnings ahead as the peak rates environment is now behind us
- Rising hard landing probability in the face of weakening economic data, justify downside protection given the sector’s YtD outperformance
European banks have been the best performing sector YtD posting a 18% return vs. only 8% for the STOXX primarily driven by the normalisation of the interest rate environment following a decade of underperformance due to headwinds from persistently low rates since the GFC. Rising bond yields together with inflation fears have helped to support earnings, notably in markets like Spain and Italy, where loans tend to be tied to market rates and together with subdued loan losses, a stronger-than-anticipated economic environment and low unemployment has translated into attractive dividends and buybacks for the sector.
However, the sector’s current outperformance reflects a blue-sky scenario ahead, where rate cuts are expected to gradually fall as expectations of a soft landing negate the need for deep rate cuts, a significant headwind to the sector’s earnings. While the performance in the banking sector reflects an optimistic view ahead, Consumer discretionary sectors like Luxury and Autos reflect a more pessimistic outlook with a weakening job market, a stressed consumer and benign growth out of China.
With peak rates likely behind us and given the sector’s strong performance over the last year, significant upside for the sector both in terms of earnings and price performance are hard to justify, in our view, and rising risks justify us looking for downside hedges. Looking at the recent results posted by US Banks, a common theme was the rising credit loss provisions, reflecting a broader environment of rising delinquencies, and although European banks are now better capitalised, following the liquidity crisis seen in March 2023 in US regional banks risks from ripple effects into European Banks from another crisis or a sharp economic downturn are hard to ignore and important to monitor.
In terms of volatility, although 6M ATM IV currently appears undemanding at a 2YPc37 and at 5YPc17 to add negative delta, on a one-year look back volatility is expensive (1YPc73) swaying our thoughts of playing downside via Mar25 125/120 Put Spreads costing 0.74% of spot (Spot ref 140, Fut. ref 141). Should the spot price tick through our price target at expiration the strategy would return 5x return on the premium employed.