HomeResearch and NewsArbat Capital: Banking Sector Report - June 2019

Arbat Capital: Banking Sector Report - June 2019

EXECUTIVE SUMMARY

US banks bounced back in June after significant decline in May despite rate expectations moved lower again. Notwithstanding, it underperformed the broad market the second month in a row. In June, US banks increased by 6.7% MoM vs +6.9% of SPX index. Absolute June performance on MoM basis was +0.9 StD from the mean and it is in the top 15% of the absolute MoM performance of BKX index. Relative June performance was -0.2% MoM, it is -0.03 StD from the mean but it is in the top 47% of relative MoM performance vs SPX index since 1992. Nonetheless, it was the second best June absolute performance over the last 28 years. Also, BKX index is still +14.2% ytd, the strongest growth of the first 6 months of the year in absolute terms over the last 6 years.

Dynamics within the sector was relatively uniform with positive performance of all members of BKX index. The key outperformers were Citigroup and Goldman Sachs that added more than 12% MoM. In turn, NYCB showed the worst performance because of negative impact of NYC rent regulation reform.

The Federal Reserve released CCAR results on June 27, about a week after the publication of DFAST results. Overall, results were markedly better than expected with significant growth of both dividends and buybacks. Median dividends growth of BKX index members was 13% vs CCAR 2018 while total buybacks of BKX index members increased by 25% to $117 Bn. Median total payout ratio increased by 23% in absolute terms to 125%. Thus, in accordance with announced dividends and buybacks, median buyback yield was 8.9% while median dividend yield was 3.2%. So, median total yield exceeded 12% vs 9% after CCAR 2018. The key winners of the stress test are JPM, BAC and trust banks while COF and USB showed relatively weak figures. Thus, BAC’s total yields exceeded 14%, JPM’s one was 11.6% while USB’s figure was just 6.8%.

The earnings season of US banks will start on July 15th, when 2Q19 quarterly report will be provided by Citigroup. After that, within two weeks, all members of BKX index will provide their quarterly results. It was a messy quarter again – probability of 2 rate cuts till the end of 2019 increased from 22% at the end of 1Q19 to 94% currently; all forward rates decreased significantly while loan growth rate remained relatively flat. According to Bloomberg consensus, median decline of 2Q19 EPS of BKX index members is -0.8% QTD or -1.6% YTD. Full-year estimates for the current and next years were also revised down YTD by -2.2% and -2.4%, respectively. But we expect more significant decline of full-year EPS estimates in the near future given very dovish Fed, substantial decline of key benchmark yields, partly inverted yield curve and weak acceleration of loan growth while fee income dynamics remains relatively poor. The risk of recession also increased markedly, from our point of view, implying that provision expense growth could accelerate while loan growth should decelerate. Notwithstanding, 2Q19 numbers should be still resilient with median growth of EPS of BKX index members of +2.7% QoQ or +6.4% yoy. But updated 2019 guidance and management’s comments are more important than quarterly figures at the moment because of recent dynamics of yields and expectations of rate cuts.

Given significant decline of key benchmark rates and lowered rate expectations, it is estimated that NIM will decline sequentially. According to Bloomberg consensus estimates, median decline of NIM of BKX index members in 2Q19 is 4 bps QoQ but it is expected to increase by 5 bps yoy. In turn, median growth of NII is +1.6% QoQ or +4.4% yoy. Estimates have already declined and we expect that projections will continue to go down. Thus, median decline of 2Q19 NII estimates of BKX index members is 0.3% QTD or -0.4% YTD. NIM has already declined by 1.3 bps QTD and 2.3 bps YTD. Fed futures (Dec 2 / 31 19/Dec 20/Dec 21) decreased significantly in June following substantial decline in May. Implied rates declined by 21.5/15/10.5 bps MoM to 1.7%/1.32%/1.35%, respectively, suggesting more than 4 rate cuts till the end of 2020 and flat FF rate in 2021. So, future rate dynamics is clearly headwind for US banks.

Overall, operating trends of US banks still remain strong with high credit quality, good cost control and positive operating leverage but there are just few profit drivers at the moment as well as less and less positive catalysts for banking shares, given significant growth YTD. Notwithstanding, banks continue to trade with substantial discount to S&P 500 index, reflecting late cycle concerns. Thus, banks are trading with -2.1/-1.8 std on P/E CY and -2.4/-1.5 std on P/E NY (on the basis of samples from 2000 and 2010 yrs to current moment) relative to historical averages. Relative to S&P 500, banks are currently trading at -2.4 and -2.2 std from the sample mean (2010-current moment) for P/E CY and P/E NY, respectively. We recommend to invest 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 and RF. Also, we add to this list C which is one of the least asset sensitive LC banks and liability sensitive SBNY. Dynamics of EU banks was weak again and they underperformed the broad market significantly in June unlike to US peers despite they moved synchronically in the previous months. But correlation between absolute monthly performance of BKX index and SX7P index since the beginning of 2018 remains relatively high (~78%). On absolute basis, SX7P index increased by 1.6% MoM in June or +0.2 std from the mean and this result is in the top 47% of absolute monthly performance of SX7P since the index inception. But relative monthly performance was -2.6% MoM or -0.7 std and it is also in the bottom 20% of relative monthly performance. In result, EU banks are +0.9% ytd and they are -11.5% ytd on relative basis after they underperformed STOXX 600 by 17% in 2018.

DBK showed the best performance among SX7P index members in June due to press reports about new restructuring plan and successful pass of CCAR 2019. In turn, Natixis was the worst performer in Europe after Morningstar suspended its rating on a fund managed by Natixis affiliate because of liquidity concerns.

EU macro data published in June was slightly positive, from our point of view, with beat on retail sales and unemployment rate, better services PMI and in-line industrial production but manufacturing PMI remains weak and consumer confidence were lower than expectations. The indices of economic surprises remained negative but they started to demonstrate encouraging dynamics. From the other hand, loan growth remains resilient despite GDP growth slowdown but it varies from country to country. ECB again was dovish at June meeting. Also, rate expectations have changed significantly in the recent months. Thus, probability of the rate cut in EU till the end of 2019 increased from 35% at the end of May to 83% at the end of June. 3M Euribor (Dec 2021) declined by 61 bps YTD to -0.36% while 3M Euribor (Dec 2022) went down by 78 bps YTD to -0.17%. So, the risk that European rates will remain negative more than five years from the current moment has increased significantly in recent months. Given relatively weak 1Q19 quarter results and significant decline of key benchmark yields, we expect further downgrades of EPS estimates which have already declined by 6.1% YTD and 6.3% YTD for 2019 and 2020 years, respectively (median EPS decline of SX7P index members). EU banks continue to trade with significant discount to historical averages (-23%/ -1.4 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 17% at the moment vs average of 15% since 2010, still minor, from our point of view, given higher risks. So, we still continue prefer US financial institutions over EU ones. But it is reasonable to remain selective in both regions given late cycle and significant decline of benchmark yields.

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