HomeResearch and NewsArbat Capital: Banking Sector Report - October 2019

Arbat Capital: Banking Sector Report - October 2019

EXECUTIVE SUMMARY

US banks outperformed the broad market in October for the second consecutive month after very weak dynamics in August. Thus, BKX index increased by 3.8% MoM in October vs +2.0% of SPX index. Absolute October performance on MoM basis was +0.5 std from the mean and it is in the top 31% of the absolute MoM performance of BKX index. Relative October performance was +1.7% MoM, it is +0.4 std from the mean and it is in the top 31% of relative MoM performance vs SPX index since 1992. Moreover, it was the best relative performance of BKX index in October over the last 7 years. BKX index is +21% ytd, and it is the strongest growth of the first 10 months of the year in absolute terms over the last 6 years. On relative basis, it is -0.2% ytd, the sixth year in a row of negative relative performance of the first 10 months of the year.

Dynamics within the sector was driven by quarterly results. Thus, STT, FRC and ZION were best performers in October due to positive EPS surprises. In turn, EWBC, SNV and NYCB markedly declined because of weaker results. NYCB decreased by 13.5% in the day of report because of decline in multifamily loans, the most intraday decline since 2015. US banks reported reasonable headline numbers due to strong fees even despite challenging rate environment. However, further dynamics of operating figures will depend on the ability of banks to mitigate negative effect of declining rates through cost cutting and/or higher loan growth what looks questionable under current conditions. 19 out of 24 of our group of banks demonstrated positive EPS surprises, slightly higher than median number of positive quarterly EPS surprises of 18 over the last 51 quarters. Thus, median EPS surprise for our group of banks was +3.2% vs median quarterly figure over the last 12.5 years of 4.1%. Moreover, revenue surprise was positive, the 15th quarter over the last 17 quarters, +1.32%, the highest one over the last three years. 20 companies of our group of banks or 83% demonstrated positive surprise on revenue, markedly higher the median quarterly figure since Q1 2007 of 63%. So, market perception of the results was clearly positive – BKX index increased by 5.2% since the start of the earnings season till the end of October while S&P 500 index increased by 2.4% over the same time. Median percent change in price around the earnings date of our group of banks of +0.6% was markedly higher than median figure since Q1 2007 of -0.3%. Notwithstanding, consensus estimates were revised down qtd. Thus, 4Q19 EPS estimate was revised down by 0.5% qtd / by 5.9% ytd (median of BKX index members), 2019 FY EPS estimate was +0.4% qtd but -3.1% ytd while 2020 FY EPS estimated declined by 1% qtd / by 7% ytd.

Total net interest income of BKX index decreased by 1.4% qoq or -0.7% yoy vs -0.3% qoq or +2.6% yoy in 2Q19 and +1.6% qoq or +4.8% yoy in 3Q18. The key driver of negative qoq dynamics was weaker NIM which was also the reason for negative NII surprise despite strong earning assets growth due to securities growth. Thus, median NII surprise of BKX index members was -0.3% while median NIM surprise was -0.7 bps. 14 out of 24 BKX members showed negative surprise on NII in 3Q19 as well as NIM of 14 out of 24 BKX members was lower than expected. Median NIM of BKX index members decreased by 11 bps qoq or -15 bps yoy vs -4 bps qoq or -3.5 bps yoy in 2Q19 and +0.5 bps qoq or +8.5 bps yoy in 3Q18. On yoy basis, it was the second consecutive decline of median NIM over the last 11 quarters.

Overall, operating trends of US banks still remain resilient but deteriorating. Despite better EPS/revenue figures NIM/NII were lower than expected as well as opex while loan growth remained soft and NCO ratio has increased recently. In result, operating leverage was negative for the first quarter over the last 2.5 years. Given more rate cuts in the near future, flat yield curve and overall low level of interest rates, we expect that revenue weakness will persist in 2020 as fee income growth from mortgage and capital markets doesn’t look sustainable. So, we perceive the recent growth of US banks as temporary relief rally due to better than feared results even despite banks continue to trade with significant discount to S&P 500 index and historical averages. Thus, US banks are trading with -1.4/-1.3 std on P/E CY and -0.9/-0.6 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 -1.9 and -1.6 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, we maintain our cautious view on US banks given higher risks and still optimistic dynamics of banking shares in 2019. NIM prospects remain weak given decline of key benchmark rates ytd and we expect that loan growth will offset it only partially as risk of recession continues to go up. Moreover, there is no big room for opex reduction given worse revenue prospects while risk of asset quality deterioration continue to go up. Capital return will remain high near term and it should be the main driver of EPS growth but it is too little to change the mood of investors given the late cycle concerns.

EU banks increased again in October after skyrocketing growth in September, the second consecutive month of outperformance following four months in a row of underperformance. On absolute basis, SX7P index increased by 1.7% MoM in October or +0.2 std from the mean and this result is in the top 45% of absolute monthly performance of SX7P since the index inception. Also, relative monthly performance was +0.75% MoM or +0.3 std and it is in the top 35% of relative monthly performance. Despite significant growth in September and October, SX7P index is still just +1.3% ytd on absolute basis while on relative basis it is -13.8% ytd with negative MoM relative performance in 6 out of 10 months of this year. The key drivers of EU banks in October were ongoing relief rally in rates, diminishing political uncertainty due to more constructive Brexit talks and quarterly results. The latter was a reason of decline for majority of banks as results remain relatively weak. Thus, HSBC, DBK and Swedbank were the worst performers in October as operating figures in 3Q19 were poor. The best performers were BPE, BARC and SAB.

Relief rally on European markets continued in October but we don’t expect that it is sustainable, especially taking into account clearly weak start of the earnings season. EU macro data published in October were better than expected but euro area growth outlook remain tilted to the downside. However, it is worth to remark that 3Q19 EU GDP growth was better than expected but it remains weak. In turn, composite PMI, which is well correlated with GDP growth, continues to point on further slowdown of the economy. It slightly missed expectations in October after significant miss in September. So, corporate loan growth declined MoM for the second consecutive month while consumer loan growth remains resilient due to tight labour market. Unsurprisingly, ECB’s October meeting which was the last one for Mario Draghi as the president was uneventful after dovish September meeting but it is noteworthy that need for fiscal easing was mentioned again.

Given negative rate environment, EU banks EPS estimates continue to go down. Thus, median decline of FY2019 EPS estimates of SX7P index is -8.6% ytd while FY2020 is -13.6% ytd. Taking into account lack of opex and NPL reduction opportunities as well as rising recession risks, EU banks continue to trade with significant discount to historical averages (-15% or -0.9 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 16.5% at the moment vs average of 15.5% since 2010, still minor, from our point of view, given higher risks.

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