HomeResearch and NewsArbat Capital: Banking Sector Report - July 2019

Arbat Capital: Banking Sector Report - July 2019

EXECUTIVE SUMMARY

 US banks outperformed the broad market in July after two consecutive months of underperformance. Thus, BKX index increased by 4.1% MoM in July vs +1.3% of SPX index. Absolute July performance on MoM basis was +0.5 StD from the mean and it is in the top 28% of the absolute MoM performance of BKX index. Relative July performance was 2.8% MoM, it is +0.6 StD from the mean and it is in the top 22% of relative MoM performance vs SPX index since 1992. Moreover, it was the best July relative performance over the last 10 years. Also, BKX index is still +18.9% ytd, the strongest growth of the first 7 months of the year in absolute terms over the last 6 years. The key driver of the sector was better than feared earnings season.

Dynamics within the sector was relatively uniform with positive performance of all members of BKX index except for ZION, PBCT and MTB whose quarterly reports were noticeably worse than expected. The key outperformers were DFS and NYCB which added more than 15% MoM due to better quarterly results.

US banks reported resilient headline numbers despite significant decline of majority of yields YTD. But underlying trends slightly worsened, especially NII/NIM prospects. 18 out of 24 of our group of banks demonstrated positive EPS surprises, in-line with median number of positive quarterly EPS surprises of BKX index members over the last 50 quarters. Thus, median EPS surprise for our group of banks was +2.7% vs median quarterly figure over the last 12.5 years of 4.2%. Moreover, revenue surprise was positive, the 14th quarter over the last 17 quarters, +0.84%, the highest one over the last two years. 15 companies of our group of banks or 63% demonstrated positive surprise on revenue, in-line with the median quarterly figure since Q1 2007. So, market perception of the results was clearly positive – BKX index increased by 2.6% since the start of the earnings season till the end of July while S&P 500 index decreased by 1.1% over the same time. Median percent change in price around the earnings date of our group of banks of +2% was the second best result since Q1 2007. Notwithstanding, consensus estimates were revised down qtd. Thus, 3Q19 EPS estimate was revised down by 2.4% qtd / -4.6% ytd (median of BKX index members), 2019 FY EPS estimate was lowered by 0.9% qtd / -2.1% ytd while 2020 FY EPS estimated declined by 2.9% qtd / -5.3 ytd.

Overall, operating trends of US banks remain resilient due to high credit quality, good cost control and still positive operating leverage despite relatively weak NII/NIM dynamics. In result, median yoy growth of operating income of BKX index members remains positive but it significantly decelerated in 1H2019. Total net interest income of BKX index members decreased by 0.3% QoQ but increased by 2.6% yoy vs -0.7% qoq or +4.8% yoy in 1Q19. The key driver of negative qoq dynamics was weaker NIM which was also the reason for negative NII surprise despite relatively resilient loan growth and higher day count in 2Q. So, because of relatively weak NIM dynamics in 2Q19, dovish Fed and upcoming rate cuts, Bloomberg consensus estimates of median NIM of BKX index members were markedly lowered QTD to 3.11% for FY2019 and to 3.04% for FY2020, -5.2 bps qtd / -10 bps ytd and -12.3 bps qtd / -17.2 bps ytd, respectively. Despite relatively weak NIM/NII figures, banks commentaries about future NIM/NII dynamics were optimistic, implying no significant yoy NII decline for majority of BKX index members in 2019 even in case of 2-3 rate cuts till the year end (including rate cut at July 31 meeting). But it is expected by management that qoq NIM dynamics will be negative in 3Q19.

Given still resilient operating trends and better than expected CCAR 2019 results, BKX index continued to outperform the broad market index. Notwithstanding banks still trade with significant discount to S&P 500 index, reflecting late cycle concerns of investors. Thus, banks are trading with -2.0/-2.1 StD on P/E CY and -1.5/-1.2 StD on P/E NY (on the basis of samples from 2000 and 2010 years to current moment) relative to historical averages. As for relative to S&P 500, banks are currently trading at -2.1 and -2.3 StD from the sample mean (2010-current moment) for P/E CY and P/E NY, respectively. Despite this, we have more cautious view on US banks as there are just few profit drivers 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 accelerate after upcoming rate cuts or not. If answer is no, we will not probably see EPS growth even despite large buybacks as loan growth will remain subdued and asset quality will possibly worsen while there is no further room for significant opex reduction given the growing need for tech investments. Capital return will remain high near term but it is too little to change the mood of investors given late cycle concerns. We recommend investing selectively and to avoid banks with weak deposit franchise as well as high revenue dependence on rate hikes. Our top picks remain BAC, JPM, MS, CFG, RF, C and SBNY.

EU banks declined in July, continuing to underperform the broad market index, the third month in a row due to relatively weak start of the earning season and lower expectations on rates. On absolute basis, SX7P index decreased by 2.6% MoM in July or -0.4 StD from the mean and this result is in the bottom 26% of absolute monthly performance of SX7P since the index inception. Also, relative monthly performance was -2.8% MoM or -0.7 StD and it is in the bottom 18% of relative monthly performance. In result, EU banks are -1.7% ytd and it is -14% ytd on relative basis after it underperformed STOXX 600 by 17% in 2018.

The key underperformers were Spanish banks whose quarterly results weren‟t strong. Moreover, their balance sheets are rate sensitive, so their quotes were negatively impacted by lowered ECB guidance on rates. From the other hand, banks with better figures than expected managed to show positive price dynamics. Given weaker economic prospects and challenging rate environment, it seems that EU banks will continue to underperform the broad market. The key policy rates remained unchanged at the July ECB meeting but it was sent the clear message that rates could be cut as soon as at the September meeting. Also, it was noted that there was the need for accommodative monetary policy for prolonged period of time because of weaker inflation. Among possible options are new asset purchases program and forward guidance on the policy rates. But mitigation measures are also on the agenda, such as “a tiered system for reserve remuneration”.

Notwithstanding, the market reaction on the meeting was restrained given few additional details about new easing measures (no timing, size and so on) and the probability of 10 bps rate cut at September meeting was assessed at 63% as the end of July (down from 81% as the end of June but up from 20% as the end of May). Also, economic outlook continues to worsen. Mario Draghi admitted that it “is getting worse and worse and it's getting worse and worse in manufacturing especially” while risks tilted to the downside but risk of recession is still assessed as “being pretty low”. The start of 3Q19 wasn‟t strong either with ongoing decline of PMI figures and negative surprise on retail sales.

Start of the earnings season wasn‟t strong with a plenty of negative EPS surprises and a number of dividend downgrades. So, EPS and revenue estimates continue to go down. Thus, median EPS decline of SX7P index members is -6.5% ytd for FY 2019 (-0.9% qtd) and -9.1% ytd for FY 2020 (-1.8% qtd). Median decline of CY revenue estimate was 2.2% ytd (-0.1% qtd). EU bank continue to trade with significant discount to historical averages (-27% / -1.7 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 22% at the moment vs average of 15% since 2010, still minor discount, from our point of view, given higher risks. So, we still continue prefer US financial institutions over EU ones.

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