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Banking Sector Report - December 2018


US banks significantly underperformed the broad market on MoM basis in December after two consecutive months of outperformance. Thus, banks decreased markedly in absolute terms during the last month. So, BKX index underperformed SPX index in five months over the last 8 and it underperformed the broad market by 14.3% in 2018. In December, US banks tumbled by 15.5% MoM vs -9.2% of SPX index. Absolute December performance on MoM basis was -2.4 StD from the mean and it is in the bottom 2% of the absolute MoM performance of BKX index (6th worst absolute monthly performance since 1992). Relative December performance was -7% MoM, it is -1.5 StD from the mean and it is in the bottom 6% of relative MoM performance vs SPX.

Dynamics within the sector was uniform with negative performance of all members of BKX index. The key underperformer was SVB Financial which lost more than ¼ of market cap in December. The best performer, Bank of New York Mellon, decreased by “just” 8.3% MoM.

Despite significant growth of earnings estimates in 2018 due to positive impact of tax reform, US banks tumbled by 15.5% in December, ending the year with -19.6% yoy performance in absolute terms, -26.6% from February highs. In result, US banks trades at -2.7-2.8 standard deviations from historical averages of P/E mean multiplies for current year and next year estimates from 2000 year despite still strong operating results. Among the key concerns that led to such a rapid decline, we can highlight less hawkish Fed, slower loan and revenue growth, possible deterioration of credit quality and increased risks of recession. We agree with the point that both revenue and profit growth will decelerate in coming years from very high levels of 2018 but we also think that it is a buying opportunity given current valuations and still low, from our point of view, probability of recession in 2019. Among our top picks remain Bank of America (BAC), JP Morgan Chase (JPM), Morgan Stanley (MS) and Wells Fargo (WFC). We remove from it asset sensitive Zions Bancorporations (ZION) and Comerica (CMA) because of lower rate hikes expectations. And we add Citizens Financial (CFG) and Regions Financial (RF) due to low valuations relative to expected profitability ratios.

Overall, the operating trends of US banks remain solid. Decelerating loan growth is no more a headwind for the industry (but not a tailwind either), while significant decline of the long end in December has a limited impact on banking profits. We expect that banks will continue to show more positive surprises than negative ones, as they did in 39 consecutive quarters before. We think that coming earnings season will confirm that the operating trends of US banks are unchanged and it should be a good driver for US banking quotes given recent sell-off. From the other hand, positive surprises didn’t transform into growth of quotes of US banks every time after the earnings season. At least, correlation between median quarterly EPS surprise of BKX index members and median one-day percent change in price around the earnings date is just 0.32 since Q1 2007.

US banks earnings season will start on January 14th, when 4Q18 quarterly reports are provided by Citigroup. After that, within two weeks, all members of BKX index will provide the quarterly results. Despite US banks qoq price decline was the worst since 1Q 2009, the street continues to revise up EPS estimates of financial institutions. Full-year estimates for the current and next years were revised up by +0.8% qoq and +0.1% qoq in 4Q18, respectively. In turn, median growth of 4Q18 EPS of BKX index members was -0.7% qoq in 4Q18. FY 2019 EPS was relatively strong in 4Q18 even despite relatively dovish Fed meeting in December. US banks remain strong with good cost control and ability to generate operating leverage, high quality of the loan portfolio, further room to NIM growth and ample capital levels. From the other hand, despite accelerating in 4Q18, loan growth remains relatively weak even in spite of GDP growth is solid; NIM growth is inevitably slowing as deposit beta has accelerated while the yield curve is near being inverted and the Fed is more dovish; uncertainty and risks increased.

European banks were also unable to avoid the sell-off in the midst of tumble of U.S. stock indexes despite a significant decline in the first 11 months of 2018. It was the third monthly decline in absolute terms for EU banks. In result, banks underperformed the broad market by 17.1% in 2018. Thus, SX7P index ended the year at the lowest level since August 2016. Absolute December performance of SX7P was -7.7% MoM or -1.2 std from the mean and this result is in the bottom 11% of absolute monthly performance of SX7P since the index inception. So, relative monthly performance was -2.3% MoM or -0.6 std and it is in the bottom 23% of relative monthly performance.

All members of SX7P index decreased in December but the divergence in performance in Europe was higher than in US. Thus, the best EU performer was Standard Chartered (as it was also in November due to generation of approximately 90% of revenues outside Europe) which was almost flat in December. In turn, the worst performer, Commerzbank, decreased by 24 MoM%. 

European economic data continues to be disappointing. The ECB also acknowledges that growth in economic activity moderated significantly in EU since the end of 2017 and that the euro area financial stability environment became more challenging since May of 2018. It is pretty obvious given that European real GDP growth of +0.2% QoQ in 3Q18 was significantly lower than both Bloomberg consensus and growth of +0.4% QoQ showed in 2Q18 and 1Q18. On yoy basis, GDP growth decreased to 1.7% (also lower than estimate of 1.8%), the lowest figure over the last 15 quarters. Economic data published in December was weak again with misses on retail sales, industrial production and PMI figures. However, ECB remains optimistic about future pace of growth - “fundamental factors supporting euro area expansion remain broadly in place. Growth is therefore projected to recover in the near term. The projected growth outlook reflects the impact of the very accommodative stance of monetary policy, improving labour market conditions, stronger balance sheets and some fiscal loosening”. Banks still continue to report good operating results but the state could change quickly given negative rate environment and high NPL ratios in some countries. Particularly as the high political uncertainty in Europe will remain next year and there are all conditions that the risks will be even higher. Next year, there will be elections to the European Parliament, national elections in several countries of EU, possible snap elections in countries such as Italy or Spain, Brexit (scenario is still unknown).

After recent sell-off, EU banks look undoubtedly attractive, from only valuations point of view, trading with a significant discount to historical averages (-23% or -1.5 Std from median P/E CY of SX7P index, sample from 2010 to current moment), but on a risk-reward basis, the situation doesn’t look so impressive as a realization of the upside depends on too many conditions. Binary outcomes of many political events imply that it is not very wise to be fully invested in EU banks right now, especially in event-driven stocks such as Italian banks (UCG, ISP), UK banks and Danske bank. It is very bumpy road ahead for EU banks in 2019 and we prefer US financial institutions over EU ones at the current moment. But it should be noted that that the first rate hike is currently closer to us that it was one year ago, while EU banks are more than 25% lower now, implying good buying opportunity albeit at an elevated risks. Among the most asset sensitive EU banks, our top picks are Commerzbank (CBK GY) and Banco Sabadell (SAB SM).

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