It’s time to short European bank stocks, say Wall Street strategists

The sector has been performing well but this could be about to change.

Following a strong performance by European banking stocks this year, investors should now bet on declines in the sector as lenders are at risk from a looming peak in bond yields, according to JPMorgan Chase & Co. strategists.

Any drop in yields, or interest-rate cuts by the European Central Bank next year, will reduce banks’ profitability, strategists led by Mislav Matejka wrote in a note Monday. They are also vulnerable to any signs of a recession in the region, the team said, advising opening a short on the sector and downgrading it to underweight from neutral.

“Banks could suffer if economies enter contraction, and if some of the very benign credit backdrop changes next year, with spreads widening and delinquencies rising,” they wrote in a note. Credit risks look likely to rise, particularly for lenders exposed to high-yield corporates, small-and-medium enterprises and commercial real estate, as refinancing needs are set to increase from next year.

The Stoxx 600 Banks Index has climbed 8% this year, outpacing the 1.7% gain in the regional benchmark. Since September 2020, banks have advanced more than 60%, a rally driven by the sharp rise in bond yields over the past three years. But the rates tailwind may be starting to fade, with the ECB last week opting not to hike the first time in more than a year.

Banks’ deposit base is likely to fall, and their net interest income is probably peaking now, the strategists said. As for the dividends and buybacks that have attracted investors, these are already “as good as they get,” while banks face the additional risk of punitive taxes under discussion in a number of countries.

The JPMorgan team said third-quarter results for banks look mixed so far. “After a long string of robust bottom-up results, it appears that earnings are starting to be more challenging,” they wrote.