Why J.P. Morgan thinks European banks are still in a "sweet spot"?

Investing.com -- J.P. Morgan says European banks remain in a “sweet spot,” underpinned by strong fundamentals, compelling valuations and disciplined capital management.

The brokerage’s analysts expect the sector’s cost of equity to fall from about 11.5% today to 10% by 2027, with a potential long-term decline toward 9%. 

That trajectory implies roughly 15% price upside over the next year and as much as 25% over time. “We maintain our constructive view on European banks,” J.P. Morgan wrote, adding that the sector “can further rerate from 8.6x P/E, 1.3x P/TBV, 15.5% RoTE in 2027E.”

Valuation remains central to the argument. European banks trade at a 34% two-year forward P/E discount compared with other sectors, a gap J.P. Morgan sees narrowing. 

Currently, the sector trades at 8.6 times 2027 estimated earnings, still below the broader market despite having outperformed in recent years.

Capital strength is another pillar. The banks in coverage are forecast to have an average common equity Tier 1 ratio of 14.2% in 2025, ranging from 11.8% to 18.3%. 

J.P. Morgan noted the quality of this capital is “significantly better post Basel 3,” reducing dilution risks that plagued the sector in earlier cycles.

The analysts estimated that banks could withstand 263 basis points of provisions before breakeven, compared with a historical peak of about 179 basis points.

Asset quality also looks stable. Nonperforming loan ratios are below 2%, while muted loan growth has helped limit risks. 

J.P. Morgan forecast cost of risk at 27 basis points over 2025-27, broadly in line with the 28-basis-point historical average.

Profitability has improved markedly since interest rates rose. Returns on tangible equity are expected at 15% to 15.5% in 2026 and 2027, well above the roughly 10% seen before the rate cycle. 

“European Banks have significantly improved their RoTE generation post rate hikes,” the analysts said. 

Importantly, net interest income, which accounts for about 60% of revenues, is driven more by deposit reinvestment than by riskier loan growth. Loan-to-deposit ratios are now below 100%, reflecting deposit growth outpacing lending.

Shareholder returns are another driver. Payout ratios are expected to remain around 75% to 80% through 2027, delivering annual dividend yields of about 5% and total yields, including buybacks, close to 8.5%. 

J.P. Morgan said bank managements have shown “excellent capital management, optimizing buybacks vs. selective acquisitions” and avoiding the poor deals of past cycles.

Cost control adds to the supportive backdrop. Expenses are forecast to grow just 1.5% a year between 2025 and 2027, below the 3% revenue growth outlook. 

That gap is expected to drive pre-provision operating profit growth of nearly 5% annually and pretax profit growth of about 6%.

Risks remain, including higher bank taxes, potential rate cuts toward 1% and increased deposit competition. 

But J.P. Morgan said that the sector’s resilience, profitability and capital strength put it in its strongest position in nearly two decades.