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Banking Sector Report - August 2018


US banks again underperformed the broad market on MoM basis, the third month of the last four. But, in fact, US banks were relatively flat over the last 5 months, trading in a narrow range of 103-111 points on BKX index. In August, US banks increased by 1.1% MoM vs +3.0% of SPX index. On the YTD basis, banks still underperformed the broad market by 4.9% as of end-August. Absolute August performance on MoM basis was +0.1 StD from the mean and it is in the bottom 49% of the absolute MoM performance of BKX index. Relative August performance was -1.8% MoM, it is -0.4 StD from the mean and it is in the bottom 31% of relative MoM performance vs SPX. August is a relatively weak month, from historical performance point of view, with negative relative MoM performance in 18 cases over the past 27 years. Consumer finance companies (SYF, DFS, AXP) were among the best performers in August due to reducing concerns about the deterioration of credit quality of the loan portfolio in the segment. In turn, trust banks showed the weakest dynamics because of the flattening of the yield curve.

The key negative trend of 2Q18 earnings season was acceleration of deposit beta growth.  Median cost of interest-bearing liabilities on qoq basis increased more than yield of earnings assets, the first time in the cycle. 2Q18 movement implies approximately 48% of incremental beta and 27% of cumulative one since the end of 2016. Banking comments on future beta dynamics weren’t uniform during the last earnings season but many of banks agreed that it wasn’t the end of NIM growth trend. Large banks with good deposit franchise were more optimistic but even small banks weren’t pessimistic about future repricing dynamics of deposits. All banks agreed that deposit beta continues to be lower than the initial expectations which, however, were based on the historical dynamics of the deposit repricing without no amendment to lower loan-to-deposit ratio, less competition from money-market and similar funds, relatively weak loan growth. Also, it was noted that it was an unusual quarter in the cycle (from the deposit cost dynamics point of view) and there should be no spikes of deposit costs in the near future even if rate hike pace is maintained.

The key drivers of a relatively low level of the deposit beta in the current cycle were a high share of excessive deposits on the banking balances (as a consequence of QE) accordingly, there was no need for price competition for these deposits (so share of non-interest bearing deposits on bank’s BSs also was very high); lower level of competition from money-market funds which were significant driver of deposit costs in the last cycle; weak loan growth and as a consequence very low level of loan-to-deposit ratio so banks also had little incentive to increase the cost of deposits; the overall low level of interest rates which also didn't encourage consumers for rate-seeking behavior even despite much easier opportunities for it using either online or mobile banking. But all these arguments are still applicable to the current moment. Figures are not so far from their extremes of this cycle. So, we do not expect a significant acceleration of incremental deposit beta growth in the near future across the overall industry and we don’t think that significant growth of deposit beta in 2Q18 is a start of the trend. Of course, both cumulative beta and incremental one will go up further but we don’t see significant reasons for growth of cumulative deposit beta higher than 50%, at least at the current moment. But it should also be noted that the peak of quarterly NIM growth is likely behind us.

At the last FOMC meeting which took place at the turn of July/August the fed funds target range was left unchanged, as it was widely expected by the market. It is still at 1.75%-2% range but the probability of further hikes markedly increased after the last meeting. The key changes were made to the wording but even they were only minor. In particular, economic activity assessment was upgraded from “solid” to “strong”. Current inflation estimate was also upgraded, so “both overall inflation and inflation for items other than food and energy remain near 2 percent (“have moved close to” earlier)”. But inflation outlook remains unchanged. It seems that the FED brings the statement in accordance with recent macro data – the economy continues to strengthen, economic activity is rising, unemployment has stayed low and household spending has grown strongly. Nevertheless, the market reaction on the meeting was positive and yields increased after it. The next meeting will be held on September 26 and the probability of another rate hike is estimated by the market at 95% (at the end of July was 80%, at the end of June was 60%).

After two consecutive months of outperformance, European banks tumbled in August, significantly underperforming the broad market. In result, SX7P index is at the 21-month low, not much higher than the pre-election level of the 2016 year. Absolute August performance of SX7P was -8.1% MoM or -1.3 std from the mean and this result is in the bottom 10% of absolute monthly performance of SX7P since the index inception. So, relative monthly performance was -5.9% MoM or -1.6 std and it is in the bottom 7% of relative monthly performance. But SX7P still significantly underperformed STOXX 600 as the end of August, -14.5% ytd. Dynamics within the sector was relatively uniform with just 6 banks with positive monthly performance. One of key underperformers was SydBank which decreased by more than 20% because of weak quarterly report. Also, weak dynamics were demonstrated by Italian and Spanish banks because of Turkish crisis, uncertainty with Italian budget and possible implementation of bank tax in Spain. The best performers were Scandinavian banks.

Uncertainty about Italy’s budget for 2019 had a significant negative impact on both Italian government bonds and shares. In result, Italian yields returned back to the high of the year (the highest level over the last 5 years). But the problem is that it will continue to influence negatively on financial markets in the near months as at best, the certainty with budget will come no earlier than mid-October. Budget draft will be released by 27 September and then it should be sent to Brussels by 15 October. If it doesn’t match to EU fiscal rules, draft budget plan will have to be revised. The probability that the first version of the budget will not pass the approval is quite high, taking into account the government coalition programme, campaign promises and fiscal constraints. So, the process may be delayed until the end of the year with ongoing volatility/growth of sovereign spreads and negative impact on both Italian banks prices and its balance sheets - spike in 10yr yields of 89 bps in 2Q18 led to decline of CET1 ratios of Italian banks from 30 bps of UCG to 84 bps of BPM.

Turkish lira collapsed in August after it had already dropped substantially YTD. Significant weakening of TRY coupled with growth of Turkish bonds yields, rising CDSs, rating downgrades and so on, all this gave rise to talk about contagion risk for European banks. Indeed, a number of EU banks have marked exposure on Turkey – BBVA, UniCredit, ING, BNP and HSBC. Overall exposure of global banks on Turkey is $223 Bn as of end 1Q18, markedly higher than exposure to Greece just before the crisis of debts of periphery countries. Despite European banks owned substantial part of Turkish banking sector, total exposure of European banks on Turkey is less than 1% of total assets of the sector. As for European economy, export to Turkey is just around 3% of total Euro area figure. Of course, exposure on Turkey is markedly higher for BBVA and UCG (11% and 5% of group assets, respectively) but even such size of exposure is manageable for them given their capital levels and sensitivity of capital ratios to TRY weakening. The key risk for both banks is loss of profits from Turkish subsidiaries which were 13% (23.5% in 2017) and 5% respectively, according to the last earnings reports but it is more than in price, given August performance of both banks  -14.6% and -18%, respectively for BBVA and UCG. However, we don’t recommend buying BBVA on dips at the moment, taking into account high exposure on Mexico + Chile and the risk of spread of crisis on other EM countries. The same recommendation applies to UCG but because of uncertainty with Italy’s budget.

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