HomeResearch and NewsArbat Capital: Banking Sector Report - May 2019

Arbat Capital: Banking Sector Report - May 2019

EXECUTIVE SUMMARY 

Dynamics within the sector was relatively uniform with negative US banks tumbled in May after significant growth in April when they outperformed the broad market by more than 5%. Notwithstanding, BKX index is still +7% ytd, the strongest growth of the first 5 months of the year in absolute terms over the last 6 years despite absolute May performance was the worst one since 2010. In May, US banks decreased by 10.2% MoM vs -6.6% of SPX index. Absolute May performance on MoM basis was -1.6 StD from the mean and it is in the bottom 6% of the absolute MoM performance of BKX index. Relative May performance was -3.9% MoM, it is -0.8 StD from the mean and it is in the bottom 13% of relative MoM performance vs SPX index since 1992. 

Performance of all members of BKX index. The key driver of shares dynamics was fears around economic growth and escalation of the trade war. The long end of the curve decreased significantly while rate expectations were lowered again. In result, the most rate sensitive banks decreased substantially, e.g. SIVB lost 20% of market cap in May.

Despite underlying trends of US banks still remained intact and reported headline 1Q19 results were solid, it is obvious for us that situation has already started to worsen. At least, rate expectations deteriorated significantly ytd. Thus, the probability of possible rate cut till the end of January 2020 increased from 20% as the end of February to 50% after March meeting and it was 100% as the end of May. May FOMC meeting was mixed, from our point of view. FOMC statement was clearly dovish as well as the market reaction on it. From the other hand, Chair Powell conveyed a hawkish message to the market during the press conference. At least, the market took it that way then and it was understandable given several previous meeting being very dovish. Notwithstanding, key benchmark yields tumbled in the second half of May because of escalation of the trade war and slowing growth prospects of US economy. In result, Fed futures (Dec 19/Jan 20/Feb 20) decreased by 28-37 bps MoM in May to 1.8-1.9%. Dec 20 FF futures yield is currently at 1.47%, -45 bps MoM that implies more than 3 rate cuts till the end of 2020. However, EPS estimates of US banks were flat MoM as well as target prices. On ytd basis, the changes were also minor. Thus, median decline of EPS CY and NY of BKX index members were just -1.3% ytd and -2.1% ytd, respectively. But we expect that we will see marked EPS downgrades in the near future as the market will evaluate possible recession scenarios given the late cycle and significant decline of key rates.

So, banks continue to trade with significant discount to S&P 500 index, reflecting late cycle concerns of investors. Thus, banks are trading with -2.6/-2.4 std on P/E CY and -2.4/-2.0 std on P/E NY (on the basis of samples from 2000 and 2010 yrs to current moment) relative to historical averages. As for relative to S&P 500, banks are currently trading at -2.5 and -2.3 std from the sample mean (2010-current moment) for P/E CY and P/E NY, respectively. Despite stocks are trading at a significant discount, we have more cautious view on US banks at the moment given higher risks and still optimistic dynamics of consensus EPS estimates of US financial institutions. NIM is currently turning from tailwind to headwind given dovish Fed, rising deposit beta, noninterest-bearing deposits runoff and flat/inverted yield curve. Credit costs will eventually normalize. It is still benign and we don’t expect significant growth of provisions until recession starts but it is no more a positive driver for banking profits. Loan growth is still weak. There is no further room for 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 already doubt that banks will fully close the current valuation gap in foreseeable future.

We recommend investing selectively and to avoid banks with weak deposit franchise as well as high asset sensitivity to rates growth. European banks continue to follow US peers, markedly underperforming the broad market in May after very strong relative performance in April. Correlation between absolute monthly performance of BKX index and SX7P index since the beginning of 2018 is 77%. On absolute basis, SX7P index decreased by 11.6% MoM in May or -1.8 std from the mean and this result is in the bottom 5% of absolute monthly performance of SX7P since the index inception. So, relative monthly performance was -6.2% MoM or -1.7 std and it is also in the bottom 6% of relative monthly performance. In result, EU banks are - 0.6% ytd and it is -9.1% ytd on relative basis after they underperformed STOXX 600 by 17% in 2018.

Just 1 bank out of 40 members of SX7P index showed positive performance in May while dispersion of performance remained relatively high. The key driver of European stocks was the earnings season which wasn’t the strong one, from our point of view. Also, weaker macro data and increased political uncertainty continues to negatively impact on EU banks. 5 banks from SX7P index lost more than 20% of its price in May but a number of them because ex. div dates.

European banks reported clearly weak quarterly results which once again pointed to the critical issues of the industry and which are unlikely to be solved in the foreseeable future given a number of headwinds have recently intensified. In result, SX7P index tumbled by 12.9% since April 24 when the Credit Suisse reported its 1Q19 results. Median decline of net income of SX7P index members was 10.5% yoy in 1Q19 driven by weak revenues, especially fee income. Core net interest income dynamics was also poor as NIM continues to go down. Median NIM declined by 4.2 bps qoq and it will be going down as yield curve continues to decline and to became flatter while the first rate hike is further away from us. Cost cutting and improving asset quality are no more profit drivers therefore median return on equity is declining within the last 4 quarters. So, expectations continue to be revised down. Thus, median decline of FY2019 revenue estimates is 1.6% ytd, -0.2% since the start of the earnings season. Predictably, decline of EPS estimates is even greater. Median EPS 2019 decline is -5.6% ytd or -0.5% since the start of reporting season while median EPS 2020 decline is -5.8%/-1.3%, respectively. Given dovish ECB and significant decline of benchmark yields, relatively weak macro figures, again higher uncertainty about Brexit, US-China trade tensions and recent concerns about sustainability of Italian debt, we expect that estimates will continue to be revised down.

After recent sell-off, EU banks again look attractive but only from absolute valuations point of view, trading with a significant discount to historical averages (- 23% / -1.5 Std from mean P/E CY of SX7P index members, sample from 2010 to the present). However, on a risk-reward basis, the situation doesn’t look so impressive as just few possible catalysts remain for them in the near future while structural problems of EU banking sector hasn’t been resolved yet and risks has increased significantly. Moreover, EU banks don’t look cheaper than US peers. Thus, discount of European banks to US peers (on median P/E CY of BKX index vs SX7P index) is just 11% at the moment vs average of 15% since 2010. Upside, implied by Bloomberg consensus price targets, is high enough but realization of the upside will depend on the macro environment and further dynamics of rate expectations. In case of no macro improvements we will just see downgrades of target prices rather than growth of quotes. Thus, median decline of price targets of SX7P index members is 7% ytd. So, it is still is a very bumpy road ahead for EU banks in 2019 and beyond. Thus, we 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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