EXECUTIVE SUMMARY

US banks were flat in May after very volatile first four months of the year. Notwithstanding, banks underperformed the broad market again, the fourth month of weaker dynamics over the last 5. Thus, BKX index increased by 0.1% MoM in May vs +4.5% MoM of SPX index. Absolute performance on MoM basis was -0.1 std from the mean and it is in the bottom 43% of absolute MoM performance of BKX index. Relative May performance was -4.2% MoM. It is -0.9 std from the mean and it is in the bottom 12% of relative MoM performance vs SPX index since 1992. It was the worst first five months of the year on both absolute and relative basis in BKX index history with the total absolute performance of -34.4% ytd and relative performance of -30.3% ytd.

After relief rally in April, when all members of BKX index increased on MoM basis, banks showed mixed dynamics in May. Outperformers were banks with relatively high share of trading and IB due to guidance for surge in capital market fees in 2Q20. Banks with weaker fundamentals underperformed.

Despite the fact that the broad market index wears a mask of nothing has happened, falling only 5.8% ytd as the end of May, credit quality of US banks will inevitably deteriorate meaningfully in the coming quarters because of deep recession even taking into account significant and timely bailout packages from the Government and liquidity injections from the Fed. Notwithstanding, key asset quality indicators remained strong so far, but banks provisioned more than $36 Bn for future asset quality deterioration in 1Q20 (partly because of CECL) and we expect that banks will reserve significantly more till the end of 2020. According to estimates compiled by Bloomberg, total provision expense of BKX index members for 2020 is $114 Bn as the end of May (min $81 Bn / max $189 Bn) or 2% of total loans as the end of 1Q20. However, corporate spreads have narrowed substantially in recent weeks as a result of the Fed decision to buy corporate bonds and other support measures. Undoubtedly, it could ease pressure on quotes for some time but it couldn’t return real business to the normal state, especially taking into account the depth of the recession and many signs of a credit bubble on US corporate markets even in pre-COVID time. Total debt of US corporates increased by more than 50% since GFC while BBB-rated debt almost tripled and leveraged loans more than doubled over this period, with majority of leveraged loans being covenant lite. Credit bubble hasn’t burst yet mainly due to low rate environment, yield seeking behavior and growing economy, but there is high risk of domino effect on that market now, from our point of view, given disruptive impact of pandemic on the global economy, even taking into account all forbearance actions of creditors and ample liquidity on the markets. US banks are less exposed to the risk than non-bank lenders, from our point of view, as lending standards were relatively tight during the all cycle, but they will not be able to avoid losses either when waive of bankruptcies begins. Also, banks noted during 1Q20 earnings season that they would ease lending standards in 2Q20, which is not consistent with fears of a prolonged recession and significant credit quality deterioration. During GFC, banks started to tighten standards to large and medium size firms as early as in 3Q07. In any case, we believe that banks have sufficient capital to absorb possible losses in case of credit quality deterioration even in case of prolonged downturn and much higher NCOs than it is expected by the market now.

US banks continue trading with significant discount both to historical averages and relative to S&P 500, but it seems that equity market is a bit out of touch with reality at the moment given the depth of global economy decline even taking into account zero rates and excess liquidity. And it is difficult to imagine that banks will outperform in short-term period given so high economic and political uncertainty. So, we still remain on the sidelines until we see the first signs of fundamentals improvement.

EU banks decreased in May after a «dead cat» bounce in April, following significant decline in each of the first 3 months of the year. On relative basis, they underperformed the broad market again, the 4^th month over the first 5 months of year. On absolute basis, SX7P index decreased by 0.5% MoM in May or -0.1 std from the mean and this result is in the bottom 39% of absolute monthly performance of SX7P since index inception. Also, relative monthly performance was -3.5% MoM or -0.9 std and it is in the bottom 15% of relative monthly performance. 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 26% as the end of May.

One of the key drivers of May performance was the earnings season. So, banks with better than expected results outperformed those, which demonstrated weaker figures. Thus, the best performers added more than 10% MoM while Banco Sabadell lost more than 28% MoM and almost ¾ of its market capitalization ytd.

European banks reported slightly better figures in 1Q20 with positive EPS and revenue surprises for majority of SX7P index members even despite median growth of provision expense was almost 200% on yoy basis while key benchmark yields tumbled ytd. Thus, 20 out of 35 banks from SX7P index for which estimates were available reported positive surprises on EPS. Notwithstanding, earnings momentum worsened significantly in 1Q20 after two consecutive quarters of positive yoy dynamics of operating profit. Median decline of operating profit of SX7P index members was 42.4% yoy in 1Q20, the most significant one since 4Q12. However, both NII and fees were relatively resilient in 1Q20 despite challenging revenue environment, while costs remain under control but growing. So, the key question is whether NII and Non-II trends are sustainable in current environment as provision expenses will inevitably go up in coming quarters. In any case, the earnings season was better than feared. So, market perception of the results was positive given significant underperformance of EU banks ytd. Thus, median 1-day performance of SX7P index members around the earnings date was +2.4% during 1Q20 earnings season while SX7P index skyrocketed by 11.8% since April 21, a day before the first member of SX7P index reported its 1Q20 results, and till the end of May while STOXX 600 index increased by 8% over the same period.

From the other hand, EU macro data remains weak even despite partial re-opening of the economy in May. Economic surprise indices are still near record lows while projections continue to be revised down. Thus, according to consensus compiled by Bloomberg, it is expected that EU GDP will shrink by 7.6% yoy in 2020 while GDP decline will be double-digit in 2Q20. Unsurprisingly, 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 5.3% ytd, -2.5% qtd, implying decline of 13.8% yoy. As of FY2021 revenue estimates, median decline is 6% ytd or -2.6% qtd. Median EPS 2020 decline is -54.4% ytd or -40.1% qtd while median EPS 2021 decline is -38.1% ytd or -24.7% qtd. Notwithstanding, it seems that EU banks have already tested the bottom given current economic estimates. And EU banks continue to trade with noticeable discount to historical averages (-16%/ -0.9 std from mean P/E NY of SX7P index members, sample from 2010 to the present) but discount to US peers (on median P/E NY of BKX index vs SX7P index) is just 15.6% 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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06 May 2020, Arbat Capital

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