EXECUTIVE SUMMARY

US banks were flat in June as it was in May after very volatile first four months of the year. But banks underperformed the broad market again, the fifth month of weaker dynamics over the last 6. Thus, BKX index increased by 0.2% MoM in June vs +1.8% MoM of SPX index. Absolute performance on MoM basis was -0.1 std from the mean and it is in the bottom 44% of absolute MoM performance of BKX index. Relative June performance was -1.6% MoM. It is -0.3 std from the mean and it is in the bottom 36% of relative MoM performance vs SPX index since 1992. It was the worst first half of the year on relative basis in BKX index history but on absolute basis it was the second worst year in index history after 2008.

It was mixed month for banks with very strong dynamics in the first week due to better than expected employment report but weaker dynamics afterwards as a result of accelerating growth of confirmed COVID cases and the Fed decision to cap dividends. So, banks with weaker stress test results were among key underperformers in June.

The earnings season of US banks will start on June 14th, when 2Q20 results will be provided by JP Morgan, Citigroup and Wells Fargo. After that, within two weeks, all members of BKX index will provide quarterly results. US banks reported very mixed figures in 1Q20 with the lowest number of positive EPS surprises among our group of banks since 4Q08, the worst quarter during GFC, but with relatively solid revenues, especially taking into account current challenging revenue environment. Underlying trends were better than feared while key reason of large number of negative EPS surprises was considerable loan-loss reserve build which will remain elevated in coming quarters. So, EPS estimates were revised down significantly since the end of 1Q20. Thus, according to Bloomberg consensus, median decline of 2Q20 EPS of BKX index members is -63.1% ytd (as end of June). Full-year estimates for the current and next years were also revised down by -53.3% ytd / -43.7% qoq and -31.3% ytd / -19.6% qoq, respectively. Notwithstanding, estimates were relatively flat in June as a result of the economy reopening and quite optimistic tone of comments from banks management. Despite loan loss provisions remain elevated and average loan rates are markedly lower on qoq basis, revenues will remain relatively resilient due to strong balance sheet growth, solid mortgage and capital market fees. Thus, revenue estimates were flat on qoq basis with median growth of BKX index members of +0.1%.

From our point of view, the main focus of investors will be on the credit quality, capital and partly on NIM dynamics. We don’t expect that key credit quality indicators will worsen significantly as early as in 2Q20 as a result of different support programs from both government and banks. But we should see the first signs of deterioration of credit quality such as growth of 30-89 days past due loans and growth of both criticized and classified loans. Notwithstanding, provision expense will remain elevated in 2Q20 and it will be even higher for some banks than it was in 1Q20. According to Bloomberg consensus, total provision expense of BKX index members will increase by 339% yoy but -13.5% qoq. Median growth of estimates is 139% qtd as a result of negative surprises on provision expenses in 1Q20. Given results of the stress test and the Fed’s decision to cap dividends as well as requirement for large banks to resubmit their capital plans, management's comments on future capital distribution policy are particularly important at the moment. At least, WFC has already announced that dividends will be cut in 3Q20. It was widely expected decision but even expected dividend cut isn’t a catalyst for the bank and the industry.

Economic situation has dramatically worsened in March and April as a result of lockdowns in the vast majority of States but recent macro figures were markedly better than expected, especially employment report, indicating that the worst is behind us. But we don’t think that we have been out of the woods yet, given the early stage of recovery and resuming growth of confirmed COVID-19 cases in the USA during two recent weeks. We don’t expect sharp improvement of banking fundamentals even if asset quality deterioration isn’t dramatic as revenue environment remains challenging with prolonged period of zero rates. Moreover, banks don’t look cheap at the moment. Thus, banks are trading with +2.4/+2.2 std on P/E CY and -0.9/-0.6 on P/E NY (on the basis of samples from 2000 and 2010 yrs to current moment) relative to historical averages (as of June 26^th). As for relative to S&P 500, banks are currently trading at -1 std and -2 std from the sample mean (2010-current moment) for P/E CY and P/E NY, respectively. On P/B, banks are trading with -1.6 std from the sample mean (2010-current moment) vs SPX which is trading with +1.7 std. Despite stocks are still trading at significant discount to S&P 500 index, we remain cautious on US banks given severity of upcoming recession and high level of uncertainty about the speed of US economic recovery.

EU banks markedly increased in June after flat dynamics in May, following very weak start of the year. On relative basis, EU banks index outperformed for the first time over the last four months. On absolute basis, SX7P index increased by 5.4% MoM in June or +0.8 std from the mean and this result is in the top 16% of absolute monthly performance of SX7P since index inception. Also, relative monthly performance was +2.5% MoM or +0.8 std and it is in the bottom 16% of relative monthly performance either. Despite weak relative dynamics in two previous years when SX7P index underperformed the broad market by 12.1% and 17.1% in 2018 and 2017, respectively, EU banks continue to lag broad market considerably. On ytd basis, SX7P underperformed by 24% as the end of June.

Dynamics of European banks was relatively uniform in June with just 6 banks in red zone out of 44 financial institutions from our group. The key outperformers were Spanish banks which were among key underperformers before. Thus, Bankia added 19.5% MoM while Banco Sabadell increased by 14.2% MoM. Among key underperformers in June were Scandinavian banks.

European macro data published in June was better than expected with positive surprises on majority macro figures. So, European economy continues to stabilize after significant decline in March and April. But expectations remained almost unchanged in June after ongoing revision down during 3 previous months. According to ECB staff projections, GDP will decline by 8.7% yoy in 2020. Also, ECB announced at June meeting that it would increase the size of PEPP by €600 mln to €1.35 bn, slightly higher than consensus of €500 mln. But it seems that PEPP size could be increased again in foreseeable future especially in case of weaker recovery than it is expected currently. Estimates continue go down while variability of them remains very high, pointing to high level of uncertainty. Thus, median decline of FY2020 revenue estimates is -0.1% MoM or -5.4% ytd, implying decline of 14% yoy. As of FY2021 revenue estimates, median decline is 0.2% MoM or -7.1% ytd. Median EPS 2020 decline is -3.7% MoM or -58.2% ytd while median EPS 2021 decline is -1.2% MoM or -41.2% ytd. Notwithstanding, it seems that EU banks have already tested the bottom given current economic estimates. As a result of significant decline of EPS estimates, EU banks is no more trading with discount to historical averages, while the discount to US peers is much lower than usually. Thus, premium to historical averages is 4% or +0.22 std (from mean P/E NY of SX7P index members, sample from 2010 to the present) while discount to US peers (on median P/E NY of BKX index vs SX7P index) is just 10.2% at the moment vs average since 2010 of 20.8%, out of synch with reality, from our point of view, given higher risks associated with EU banks which have not fully recovered from the previous crisis yet. So, we continue prefer US banks to EU ones at the moment.

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07 July 2020, Arbat Capital

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