HomeResearch and NewsArbat Capital: Banking Sector Report - March 2020

Arbat Capital: Banking Sector Report - March 2020

EXECUTIVE SUMMARY

Collapse of US banking quotes continued in March after very weak performance in January and February amid further spreading COVID-19 around the world. The broad market was underperformed substantially for the third consecutive month after 4 months in a row of leading dynamics. Thus, BKX index tumbled by 28.6% MoM in March vs -12.5% MoM of SPX index. Absolute performance on MoM basis was -4.2 std from the mean and it is in the bottom 1% of absolute MoM performance of BKX index. Relative March performance was -18.3% MoM, it is -3.8 std from the mean and it is also in the bottom 1% of relative MoM performance vs SPX index since 1992. It was the worst month on both absolute and relative performance since January 2009 and the second worst month for BKX index since the index inception. Also, it was the worst quarter for BKX index in the history.

All members of BKX index demonstrated negative dynamics in March, the second consecutive month of quotes decline for all members of the index. The best performing companies lost 13-21% in March while the worst performing ones tumbled by more than 40% MoM.

The earnings season of US banks will start on April 14th, when 1Q20 results are provided by JP Morgan and Wells Fargo. After that, within two weeks, all members of BKX index will provide quarterly results. So far, US banks have reported reasonable headline numbers but estimates have been revised down recently, given significant decline of key benchmark rates and challenging economic environment. According to Bloomberg consensus, median decline of 1Q20 EPS of BKX index members is -5.2% qtd (as end of March). Full-year estimates for the current and next years were also revised down by -6.9% and -6.1% ytd, respectively. Given recent turmoil on financial markets and as a result further contraction of US economy, we think that FY20/21 EPS estimates will continue to go down further, after 1Q20 earnings season, even despite we expect that 1Q20 figures will be more resilient than it is feared, but better reported figures are of least interest to investors now. To understand the current situation and future prospects, banks' comments on recent trends are much more important now, than ever before in this cycle.  Moreover, estimates still remain optimistic and median change of 1Q20 revenue estimates of BKX index members is +0.1% ytd as the end of March.

It was expected that the Fed would announce additional measures of monetary easing at its March meeting, but reality has made its own adjustments and the rate was cut to zero, target range 0-0.25%, without waiting for the scheduled meeting (the level where it was from Dec 2008 to Dec 2015). Also, many other stimuli were announced to provide funding/liquidity to the market to mitigate the impact of the coronavirus on the economy. Announced measures have already impacted positively on US economy, reducing the level of stress considerably but even these unprecedented measures won’t prevent significant contraction of US economy in the nearest quarters, even taking into account fiscal stimulus of $2 trln. Some estimates imply that US economy will contract by more than 30% annualized in 2Q20 while unemployment rate will exceed 10%, high of the Great Recession. So, we do not exclude that new measures to support the economy will be announced in the near future. But the efficiency of these measures will be low if economy is still somewhat paused because of even partial lockdown caused by coronavirus spreading.

But the situation with COVID-19 is still worsening. Number of confirmed COVID-19 cases increased tenfold during March and even the growth rate in percentage terms continues to grow, implying that we are far from even peak number of daily cases. So, strict quarantine measures will remain in place for weeks, if not months. It seems that peak daily cases in Italy and Spain (the most affected European countries by coronavirus) are behind us but current number of daily cases remains relatively stable at elevated levels despite it. So, hopes for a sharp improvement of the situation after reaching the peak of morbidity are not justified. It just means that probability of V-shaped recovery tends to zero. So, banking fundamentals will deteriorate meaningfully in the near term. Unsurprisingly, banks are trading with significant discount to historical averages as risks continue mounting. Also, EPS forecasts lag behind reality, understating real multipliers. Thus, banks are trading with -3.8/-3.5 std on P/E CY and -3.7/-3.2 std on P/E NY (on the basis of samples from 2000 and 2010 yrs to current moment) relative to historical averages (as of March 27). As for relative to S&P 500, banks are currently trading at -2.9 and -2.8 std from the sample mean (2010-current moment) for P/E CY and P/E NY, respectively.

Despite stocks are still trading at a significant discount to both S&P 500 index and historical averages, we maintain our cautious view on US banks given upcoming recession and deterioration of credit quality. So, we remain neutral on US banks until we see the first signs of fundamentals improvement. Also, bear market rally in the last week of March after significant sell-off before markedly diminished attractiveness of US banking shares given no catalysts ahead, at least in the nearest months.

European banks continued its rapid decline in March after a small breathing period in the first half of February. In result, it again significantly underperformed the broad market index in March, the third consecutive month of lagged dynamics after 4 months in a row of outperformance at the end of last year. On absolute basis, SX7P index tumbled by 29.5% MoM in March or -4.6 std from the mean and this result is the worst monthly performance of SX7P index since the inception. Relative monthly performance was -17.3% MoM or -4.7 std and it is also the worst month in the history of SX7P index.

Corporate news did not play a significant role and everything was determined by news of the spread of COVID-19 around the world. So, dynamics within the sector was uniform with decline of all members of SX7P index in March. The best performing banks decreased by 13-19% MoM while the worst performing companies lost 40-60% MoM in March. In result, many of SX7P index members are not far from their all-time lows.

European macro data published in March was clearly negative in the first place because of significant drop of PMI indices. Composite PMI (preliminary figure), which is well correlated with GDP growth, markedly missed expectations in March even despite expectations were very pessimistic, pointing to decline of GDP as early as in 1Q20. It tumbled by 20.2 pts to 31.4 pts vs consensus of 38.8 pts, all-time low. It was driven by services PMI which moved below 30 pts. Unsurprisingly, ECB announced many new measures to support economy, but not everything depends on the actions of the monetary authorities. The longer strict quarantine the more problems for EU economy and more losses for EU banks which are forced to exist in very challenging revenue environment, accompanied by long period of negative rates and upcoming growth of NPLs while the capabilities to mitigate revenue decline through cost cutting are limited. ECB’s liquidity and capital relief measures are helpful for banking quotes as risk of dilution is reduced significantly but fundamentals remain weak. So, we expect that estimates will continue to go down. As the end of March, median decline of FY20 EPS of SX7P index members is 18.1% ytd, FY20 revenue -2.3% ytd, FY20 NII -1.6% ytd, FY20 provision +27.5% ytd. EU banks continue to trade with significant discount to historical averages (-37%/ -2.2 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 7.8% at the moment vs average of 15.4% since 2010 or +1 std, 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. Moreover, despite SX7P index is not very far from all-time low, we could see further decline of European banks if restrictions remains for more than a month.

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