HomeResearch and NewsArbat Capital: Banking Sector Report - August 2019

Arbat Capital: Banking Sector Report - August 2019

EXECUTIVE SUMMARY

US banks underperformed the broad market in August after strong price dynamics in July, the third month of underperformance over last four. Thus, BKX index decreased by 8.8% MoM in August vs -1.8% of SPX index. Absolute August performance on MoM basis was -1.4 std from the mean and it is in the bottom 7% of the absolute MoM performance of BKX index. Relative August performance was -7.1% MoM, it is -1.5 std from the mean and it is in the bottom 7% of relative MoM performance vs SPX index since 1992. Moreover, it was the worst August both relative and absolute performance over the last 8 years. Despite this, BKX index is still +8.5% ytd, the strongest growth of the first 8 months of the year in absolute terms over the last 6 years.

Dynamics within the sector was relatively uniform with negative performance of all members of BKX index except for NYCB which is a liability sensitive bank while the key driver of the sector was decline of benchmark yields. So, the worst performers were CMA and SIVB which are some of the most asset sensitive names among BKX index members.

The publication of minutes of July Fed meeting and Powell‟s speech at Jackson hole brought us little news. But it was again confirmed that it was insurance cut at July‟s meeting to mitigate negative effect of US-China trade tensions and slowing global economic growth on US economy. So, Trump‟s tweets and trade war escalation had a very big impact on rates dynamics in August, as well as on banking quotes. It is all about rates now. First of all, rate expectations were lowered significantly in August. Thus, the markets are absolutely sure that the rate will be lowered at the next FOMC meeting vs just 63% probability as the end of July. Moreover, the probability that the rate will be cut twice till the end of 2019 is 84% currently vs 32% as the end of July. Futures imply that there will be 4 rate cuts till the end of 2020. And it is clearly a headwind for US banks taking into account that majority of them are highly asset sensitive. Second of all, the yield curve became inverted and it was the clear signal of the upcoming recession in the past. Given still relatively strong but worsening macro data, markets question how credible as indicator of recession is inversion of the yield curve at the moment, taking into account distorting effect of QE and so on. According to the last Bloomberg survey of US economic forecasts, the probability of recession within next 12 months is 35%. Anyway, an inverted yield curve is bad for banks on its own, even if there is no recession. So, NIM estimates for FY 2019/2020 continues to go down and decline accelerated after the last earnings season. Thus, median NIM of BKX index members for FY 2019 declined by 0.5 bps MoM or -6.5 bps ytd to 3.1% as the end of August. FY 2020 NIM declined by 1.3 bps MoM or -18.1 bps ytd to 3.03%. In turn, 3Q19 EPS estimate was revised down by 0.3% MoM / -2.7% qtd / -4.7% ytd (median of BKX index members), 2019 FY EPS estimate was lowered by 0.1% MoM / -1% qtd / -2.3% ytd while 2020 FY EPS estimated declined by 0.9% MoM / -3.9% qtd / -6.5% ytd.

Banks still trade at significant discount to S&P 500 index, reflecting late cycle concerns of investors and lower rate expectations. Thus, banks are trading at -2.3/-2.1 std on P/E CY and -1.7/-1.3 std on P/E NY (on the basis of samples from 2000 and 2010 yrs to current moment) relative to historical averages. As for relative to S&P 500, banks are currently trading at -2.5 and -2 std from the sample mean (2010-current moment) for P/E CY and P/E NY, respectively. Despite it, we have more cautious view on US banks as we see just few profit drivers for them at the moment as well as less and less positive catalysts given ongoing decline of the key benchmark rates and weaker prospects of the economy. The key question is whether US economy will go into recession or not. If answer is yes, banking quotes will continue decline even despite we don‟t expect that possible recession will be severe.

EU banks decreased again in August, continuing to underperform the broad market index, the fourth month in a row due to relatively weak earning season and ongoing decline of key benchmark yields. On absolute basis, SX7P index decreased by 7% MoM in August or -1.1 std from the mean and this result is in the bottom 13% of absolute monthly performance of SX7P since the index inception. Also, relative monthly performance was -5.4% MoM or -1.5 std and it is in the bottom 8% of relative monthly performance. In result, EU banks are -8.6% ytd and it is -18.6% ytd on relative basis after it underperformed STOXX 600 by 17% in 2018.

Just 2 out of 40 European banks demonstrated positive price dynamics in August. GLE FP added 3.8% due to better quarterly results while ISP IM increased by 1.1% MoM due to significant decline of Italian sovereign yields, 10yr generic yield is currently less than 1%, from 2.74% as the end of 2018. In turn, the worst dynamics was demonstrated by banks with weaker quarterly figures. For example, SYDB DC decreased by 13.3% on the day of report and it ended August with MoM decline of 19.2%.

European banks reported weak figures for the second quarter in a row because revenue environment is becoming more and more challenging. Given intensification of US-China trade tensions, slowdown of the global economy, significant decline of key benchmark yields and substantially lower expectations on rates, we expect that EU banks will continue to report poor operating figures in the coming quarters. So, perception of quarterly results was negative. Median 1-day underperformance of SX7P index members vs SX7P index around the earnings date was -0.22% during 2Q19 earnings season. In turn, SX7P index tumbled by 10.9% since the end of July 10, a day before the first member of SX7P index reported its 2Q19 results, and till the end of August while STOXX 600 index declined only by 2% over the same period. But it is worth noting that quarterly results weren‟t the key driver of banking stocks for the last couple of months. Median decline of net income of EU banks was 5.7% yoy in 2Q19 following decline of 8% yoy in 1Q19 and -1.1% yoy in 4Q18 after 7 consecutive quarters of positive yoy growth of net income. The key drivers of weak NI dynamics were poor revenues, higher opex and provisions uptick. So, median ROE of EU banks declined by 54 bps yoy to 8.5%. The key disappointment of the earnings season is not the figures themselves, but the weak outlook, especially NII/NIM guidance. Consequently, expectations continue to be revised down. Thus, median decline of FY2019 revenue estimates is 2.3% ytd, -0.1% qtd, implying decline of 7.7% yoy. As of FY2020 revenue estimates, median decline is 3.6% ytd or -1.1% qtd. Median EPS 2019 decline is -7.4% ytd or -0.9% qtd while median EPS 2020 decline is -11.4%ytd or -3.1%qtd.

Given weaker revenues and higher risks, European banks continue to trade with marked discount on both historical averages and US peers. However, from our point of view, they are cheap but they are cheap for a reason. Thus, EU banks trading at 7.7x P/E CY vs median for the sample from 2010 to the present of 11.1x, -1.8 std. For P/E NY it is -1.1 std for the same sample. But vs US peers current discount (on median P/E CY of BKX index vs SX7P index) is 22% vs average of 15% since 2010, just -0.8 std while operating environment of US peers are much less risky, from our point of view. Upside, implied by Bloomberg consensus price targets, is around 30% at the moment, near the highest level over the last 3 years, +1.6 std from the mean for the sample since 2010 but the full realization of the upside is highly questionable, from our point of view, taking into account weak and declining revenues, high political uncertainty and deceleration of GDP growth. The key problem for EU banks is lower for longer interest rate environment while structural problems of EU banking sector hasn‟t been resolved yet. We don‟t see catalysts for EU banks near term and we believe that only one reason to buy them at the moment is cheap valuation.

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