European banks set to outshine U.S. peers in 2011

A sign for Bank Street and high rise offices are pictured in the financial district Canary Wharf in London October 21, 2010.

LONDON/PARIS (Reuters) - European bank shares have started 2011 with a bang, bounding ahead of their U.S. peers, and durable profitability and low valuations mean this outperformance should last.

So far this year the MSCI European bank sector .MIEU0FN00PEU is up 11 percent compared to a 6.6 percent gain for the wider index .MSCIEU000U and a 4.4 percent rise for U.S. peers. .MDUS0FNI0PUS.

That's a stark contrast with last year when European banks dropped 6.4 percent.

Some of the factors that weighed then still lurk in the background now -- rising regulatory costs, damage from troubled peripheral euro zone economies and tough investment bank conditions.

But bulls reckon the flight from the sector has been overdone, and low valuations and a more benign economic and corporate outlook will offer support. Some say new European regulations may be less punishing than feared and tough U.S. rules could even offer opportunities.

"Lots of people don't look at (banks) because they are hard to analyse and they have underperformed," said David Crawford, manager of the Octopus Absolute Return Equity fund.

But, he added: "There's potential to make a lot of money."

According to a recent Merrill Lynch survey European investors are 50 percent underweight banks, making it the least favoured sector for the region's fund managers.

Volatility in the sector also keeps some players at bay. Santander's (SAN.MC) results -- an 8.5 percent fall in annual profits caused by tumbling Spanish property prices -- highlighted on Thursday some of the ongoing risk.

PRICING POWER, U.S. FEARS

However, the carnage wrought by the credit crisis in Europe could now help the survivors. With fewer competitors left on the scene they have more leeway to raise prices and carve up market share.

"Bank failures (in Europe) combined with increased capital requirements should result in a secular improvement in pricing power for years to come," Societe Generale said in a note.

In contrast the debt worries which plagued European banks may weigh on U.S. banks this year. They are heavily exposed to state finances, which look stretched, and investors are fretting about the government's ability to service its mammoth $14 trillion debt pile.

"There is a remote risk that the United States runs foul of the bond market if investors decide that ever higher debt is unsustainable," Dirk Hoffmann-Becking, senior analyst at Bernstein, said.

"There's no indication right now that this is going to happen, but it is a risk that people are looking at and it's not being priced in."

Europe is seen to be making progress -- albeit slow -- on economic policy coordination and on strengthening the currency bloc's rescue fund.

Spain, which had been looking like it might follow Ireland and Greece into debt default, won a confidence boost this week when its borrowing cost fell sharply, illustrating easing tensions as markets expect decisive action to draw a line under the crisis in the coming weeks.

REGULATION UPSIDE

JPMorgan analysts this month switched their overweight stance on U.S. investment banks to their European peers and pointed to regulatory changes as a reason for the move.

The U.S. government is in the midst of implementing reforms that will bring in more oversight, more limits on risk and less latitude to engage in some once lucrative businesses.

In particular, the Volcker Rule will restrict how firms trade with their own money for the benefit of clients, as well as for their own book.

While European regulators are applying pressure in the form of stress tests and raising the prospect of breaking up some of the biggest state-aided banks, the wrangling among European member states on how punitive bank regulation should be suggests that the final version may well be weaker than critics had hoped.

Any resulting disconnect between banking oversight in Europe and the U.S. could even provide opportunities for European investment banks to pick up business.)

TEMPTING VALUATIONS

Valuations look tempting too, with prices still depressed.

Despite this year's rally, the European banking index is still down 3.7 percent since early August, as simmering fears of debt restructuring or default by one of the debt-ridden countries in the euro zone kept investors away from the sector.

Bank shares are trading on an average of 9.2 times expected 2011 earnings (P/E ratio), well below the index's 10-year average of 11.1, according to Thomson Reuters Datastream.

Europe's broad STOXX 600 index .STOXX carries a forward P/E of 11.07, while the MSCI U.S. bank index has a forward P/E of 12.9, just below a 10-year average of 13.3.

Societe Generale said a P/E ratio range of 8-9.5 times has been the most lucrative for investors on a three-year compound average growth rate, returning an annualised 15.9 percent.

(Graphics by Scott Barber; editing by Sophie Walker)