(Reuters) -Resurgent European bank shares, up over 40% this year, face testing times with sentiment already being challenged by renewed French uncertainty.
Still, investors may find it hard to ignore the pull of Europe's best performing sector of the year so far. An investor who bought into European banks five years ago is sitting on a net return of around 300%, versus 70% for the broader market, LSEG data shows.
Strong earnings, bolstered by relatively higher interest rates in the past few years - before recent cuts - and brighter growth prospects have driven the rally, with a majority of banks outperforming earnings estimates.
Morningstar senior equity analyst Johann Scholtz argues that alongside falling rates, future earnings are likely to be flat-to-lower with tariffs potentially lifting companies' bad-loan provisions, which RBC says have been stable until now.
"We definitely expect corporate defaults to increase as a result of tariffs," said Scholtz.
Morgan Stanley analysts said Q2 earnings supported a view that net interest income (NII), the difference between earnings on loans and investments and what banks pay on deposits, has bottomed sooner than expected and notes growth should resume in 2026.
2. NO MORE RATE CUTS
Even if earnings momentum ebbs, banks should draw support as European Central Bank rate cuts near an end while the negative-rates era appears firmly in the past.
"People really underestimated the damage that zero and negative interest rates, that we had for a decade, did to European banks," said Morningstar's Scholtz.
A recent European Parliament study found that European banks are especially sensitive to rates compared to U.S. peers, with NII making up 60% of net operating income.
While rates have fallen from a peak of 4%, they are not expected to drop much below 2% as an EU-U.S. tariff deal eases economic uncertainty.
"We're almost in a sweet spot where banks are able to finally benefit from these deposit franchises that they have, but at the same time, you're not seeing that stress on the credit side," said MFS Investment portfolio manager Shanti Das Wermes.
Expectations that further UK rate cuts are limited have supported NatWest, Lloyds and Barclays. Their shares are up 35-50% this year, still below where they traded pre-crisis in 2008.
3. WINNERS, LOSERS
A sign of confidence in banks' prospects of generating more shareholder value is a rise in the price-to-book ratio for the average lender in the STOXX Europe 600 Banks index, comparing a lender's market value with the value of its assets. It's risen to 1.12, after years of trading below one.