Banking stocks are generally considered some of the safest equities to hold, providing investors with great long-term capital appreciation, solid dividend growth, and robust share repurchase programs. That doesn’t mean there aren’t risks associated with banking stocks.

Banks rely on businesses and consumers to spend and borrow money. During recessions, discretionary spending tends to fall, with fewer people buying large ticket items like cars and houses or using their lines of credit. Moreover, if consumers cannot repay their debts, they are at risk of defaulting on their loans, which banks have to absorb.

One of the biggest ways that banks make money is by taking in deposits, lending the money, and making a profit from the difference in interest rates. As a result, banks make less money during low-interest rate environments and more when interest rates are on the rise.

How Are European Banks Doing?

In an effort to tame runaway inflation, central banks around the world have been raising their key lending rates. The Eurozone interest rate is at 2.5% and is expected to rise to 3.25% in 2023. The Bank of England’s base rate is 3.50% and the Swiss National Bank recently lifted its interest rates to one percent.

Despite economic headwinds and fears of a recession, European banks are doing very well, reporting strong profits, improved balance sheets, and strong liquidity. But investors remain nervous and concerned that rising defaults and a recession will cut into earnings and weigh down dividend payments and buybacks.

Their concerns may be misguided. U.S. banking giant Morgan Stanley predicts that European banks’ pre-provision profits will increase 16% in 2022 and a further eight percent in 2023. European banks are also expected to return at least €100 billion (CAD$1.45 billion) through dividends and stock buybacks.

Rising interest rates are helping fuel earnings growth through significant increases in net interest income, with the amount charged for loans rising faster than the rate paid out on deposits.

How Will European Banks Navigate Rising Interest Rates?

Generally, banking stocks do not do well during recessions. But the rising interest rate environment has positioned European banks for a strong 2023. Moreover, fewer analysts are calling for a European recession this year.

The fact is, some of Europe’s largest banks are posting stronger-than-expected profits, juiced in large part by higher interest rates. Interest rates were kept at near-record lows since the financial crisis, more than a decade ago. Now, with rates rising at their fastest pace in decades, banks are cashing in.

In Germany, Deutsche Bank AG reported third-quarter earnings that came in above estimates. Italy’s UniCredit SpA increased its 2022 earning guidance after third-quarter profits rose above forecasts. Meanwhile, Britain’s Barclays PLC and Standard Chartered PLC, and Spain’s Banco Santander SA also posted better than expected results.

These results are in contrast to the mixed results coming from big U.S. banks, where profits were down, largely as a result of a sharp decline in deal-making. European banks are less reliant on deals for revenue and profits than U.S. banks and have been benefitting from the rising interest rate environment.

As a result, European banks are more than resilient enough to handle the effects of rising interest rates. What they will need to prepare for, though, is the normalization of inflation and the return of lower interest rates. But again, European banks have thrived in an ultra-low interest rate environment since 2008.

How Will European Banks Perform in 2023?

On the surface, it may not seem like a great time to invest in European banks. Gross domestic product (GDP) growth has slowed across much of Europe with a potential recession increasing credit risks and the demand for energy creating additional headwinds.

Many believe a recession is all but inevitable in 2023.

Historically, recessions come after periods of monetary tightening approximately 80% of the time. A recession is loosely described as two consecutive quarters of negative growth. So technically, we could be at the start of a recession and not know it.

It’s a different story though for Europe, the world’s largest economic region, with economists at Goldman Sachs saying it doesn’t look like it is going to tip into a recession. Economists expect the Eurozone to contract in the fourth quarter of 2022 but expect it to rebound slightly in the first quarter of 2023. For the full year, Goldman expects the Eurozone economy to climb 0.6%, a big increase from the previous call of a 0.01% dip.

There are three primary reasons why Europe is expected to avoid a recession in 2023: the industrial sector has been resilient, natural gas prices are down, and the Chinese economy is reopening earlier than expected.

Some European economies will fare better than others in 2023. Germany and Italy are expected to flirt with a recession owing to their reliance on Russian gas imports. France and Spain, though, have more diversified energy sources and are also more service-sector intensive.

Worst-case scenario and Europe does enter into a recession in 2023, it is expected to be mild.

So far, the European banking sector has been more than resilient to the challenges it is facing. It has had more than 10 years of near-zero interest rates and other headwinds to help strengthen its balance sheet. The tide has turned, with interest rates on the rise, and European banks are thriving.

Looking to Invest in European Banks?

Those looking to invest in the largest European banks can do so through a number of different strategies. One way would be to purchase shares in each company. But that would be exceptionally costly.

Another option for investors to gain exposure to the biggest European banks is through an exchange-traded fund (ETF).

Investing in European Banks with EBNK ETF

The Evolve European Banks Enhanced Yield ETF (EBNK ETF) is an index-based ETF that invests in equity securities of the largest European banks on an equally-weighted basis, with the added value of a covered call strategy applied on up to 33% of the portfolio. Covered call options have the potential to provide extra income and help hedge long stock positions.

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