HomeResearch and NewsArbat Capital: Banking Sector Report - February 2020

Arbat Capital: Banking Sector Report - February 2020

EXECUTIVE SUMMARY

US banks tumbled again in February after very weak performance in January amid spreading COVID-19 around the world. The broad market was underperformed substantially for the second consecutive month after 4 months in a row of leading dynamics. Thus, BKX index decreased by 12.5% MoM in February vs -8.4% MoM of SPX index. Absolute performance on MoM basis was -2 std from the mean and it is in the bottom 4% of absolute MoM performance of BKX index. Relative February performance was -4.5% MoM, it is -1 std from the mean and it is in the bottom 11% of relative MoM performance vs SPX index since 1992. It was the worst start of the year on absolute basis since 2009 year and the third worst start of the year on relative basis over the last 28 years. Banking quotes slightly increased in the first three weeks of February after relatively weak January dynamics but BKX index lost 15.2% in the last week of the month because of total sell-off amid coronavirus spreading. The worst performing banks lost more than 15% in February or 24-27% ytd.

Spreading of the coronavirus outside China overshadowed all corporate news in February and it led to financial markets collapse in the last week of the month. Nobody still knows the economic impact of the outbreak but fears drive markets. It is obvious that China growth significantly decelerated in 1Q20 – transportation sector, auto and property sales were especially affected. The key question is whether Global recovery will be V-shaped or U-shaped. The risk that it will be U-shaped has increased markedly in recent weeks. At least, majority of China industries operated significantly below normal levels in February. The key reason is unprecedented quarantine but, from our point of view, it was the best choice that the Chinese authorities could make in these circumstances, even at such a huge price. It seems that authorities of developed countries will not be so decisive and this will eventually lead to much more serious consequences for the economy.

Also, it is very probable that Italy and France, which showed negative GDP qoq growth in 4Q19, will fall into recession if coronavirus problem isn’t fixed in the coming weeks, especially taking into account that most cases are concentrated in the Northern regions which accounts for the lion’s share of Italian GDP. At least, European manufactory PMI published in February indicates that supply chains have already disrupted. Unsurprisingly, the worst performers are banks which will suffer from lower rates, loan growth deceleration and higher problem loans. Moreover, some banks have already announced that they curbs their business travels to the most affected regions implying that IB fees will also markedly decline in 2020, at least in 1Q20.

There have been not so many cases in US yet, but supply chain disruption could lead to negative earnings growth which is quite risky for US economy given significant growth of corporate debt and leverage loans in the last cycle. We expect that both banks and nonbank lenders will tighten lending standards in that case and it will be hard to refinance debt for commercial borrowers, especially BBB- and lower rated obligors, while profit will eventually going down markedly. So we could see rating downgrades and further sell-off on the HY market but even markedly lower FF rates could not help these companies because of flight to safety. Rating downgrades could lead to the domino effect on the high yield bonds market. So, we have already seen substantial growth of CDS prices recently.

It is obvious for us that US/EU economy will at least decelerate in the near future. It will depend on monetary/fiscal policy actions whether the deceleration transforms into decline. And it seems that monetary stimulus without any fiscal easing isn’t very helpful in the current environment as efficiency of monetary stimulus still remains questionable. But there is also not very big room for fiscal stimulus in many countries. Currently, key benchmark yields continue to fall sharply while the yield curve again flat/inverted in the middle part, pointing that the central banks could start to act as early as possible. The nearest ECB/FED meetings are scheduled in the middle of March. It is quite possible that rates will be lowered again. At least, according to Bloomberg WIRP, it is implied that rates will be lowered 3.6 times in US and 2.1 times in EU till the end of 2020 (as of February 28). Also, the European yield curve is below 0%, while 10yr US treasury yield continues decline to record lows. Cutting the fed funds rate to 0% this year doesn’t look unlikely. But lower rates aren’t a panacea, from our point of view, as liquidity is unlikely to reach those who really need it. Nobody wants to be an emergency lender during the perfect storm. From the other hand, it will undoubtedly reduce banking NII, especially regional banks, given relatively high share of C&I loans on their BS. If it is the case, we will see rising corporate defaults and significant growth of problem loans in C&I segment. Consumer segment will also suffer but we don’t expect that NCO/NPL ratios will be even close to the peaks of mortgage crisis. Overall, operating trends of US banks were solid so far but gradually deteriorating because of challenging revenue environment and weak commercial loan growth while consumer business is still strong as well as credit quality.

But it is obvious that EPS estimates will be lowered markedly in the coming weeks as there is no EPS drivers in the near future except for high buybacks, especially taking into account slowdown of Global economy and significant decline of the key benchmark rates ytd. Unsurprisingly, banks continue to trade with significant discount to historical averages (but it will be partially mitigated by decline of EPS estimates in coming months) and discount to S&P 500 index increased markedly in February due to higher probability of recession. Thus, banks are trading with -2.2/-2.2 std on P/E CY and -2.3/-1.9 on P/E NY (on the basis of samples from 2000 and 2010 yrs to current moment) relative to historical averages (as of February 28). As for relative to S&P 500, banks are currently trading at -2.2 and -2.1 std from the sample mean (2010-current moment) for P/E CY and P/E NY, respectively.

It was very controversial month for European banks with strong performance in the first weeks of February but SX7P ended the month deeply in the red zone because of sell-off in the last week of the month. Notwithstanding, it was flat on relative basis after weak relative dynamics in January, following two years in a row of significant underperformance. On absolute basis, SX7P index tumbled by 8.4% MoM in February or - 1.3 std from the mean and this result is in the bottom 9% of absolute monthly performance of SX7P since the index inception. In turn, relative monthly performance was +0.1% MoM or +0.1 std and it is in the top 45% of relative monthly performance.

The key drivers of EU banks in February were relatively good 4Q19 earnings season, expectations of higher M&A volumes and risks of further spreading of coronavirus across the European countries. Contrary to US banks, not all members of SX7P index decreased in February. Thus, UBI Banca skyrocketed by 37% MoM due to ISP’s bid of $5.3 Bn. From the other hand, ABN AMRO lost more than 1/5 of the market cap in February.

EU banks EPS estimates will continue to go down despite some signs of operating trends stabilization during 4Q19 earnings season as risks of recession (primarily in Italy and France) increased, accompanied by significant decline of key benchmark rates. So, EU banks continue to trade with significant discount to historical averages (-25%/ -1.5 std from mean P/E CY of SX7P index members, sample from 2010 to the present) but discount to US peers (on median P/E CY of BKX index vs SX7P index) is just 14.3% at the moment vs average of 15.5% since 2010 or +0.2 std, inappropriate, from our point of view, given higher risks associated with EU banks. Moreover, despite SX7P index is just 8% higher than 2011 low, we could see further decline of European banks if coronavirus problem isn’t be fixed quickly.

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