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Report

Banking Sector Report - February 2017

EXECUTIVE SUMMARY

In February US Banks added +4.9% (the closing price on Friday, February 24) vs +3.9% of S&P 500 Index. However, SPX slightly outperforms financial sector YTD: +5.7% vs +4.4% of BKX index. Current absolute February performance is just +0.6 StD from the mean monthly performance and this result is in the top 25% absolute monthly performance of BKX Index for all available performance data for BKX Index from Bloomberg. Relative outperformance vs SPX index in February was +1.0% and it is just +0.2 StD from the mean.

Dynamics within the sector was relatively uniform and there were only 6 banks with negative performance during the last month. Outperformers were SVB Financial, Bank of NY Mellon and Regions Financial all of which are highly sensitive to rising interest rates. Banks outperform broad market even despite recent weak rates dynamics.

Macro data continue to demonstrate strong optimism both in corporate sector and in consumer segment. However, number of positive macro surprises is no more growing, though it is still near multi-year highs.

Corporate loan growth continues to slow down despite recent significant business optimism, positive banking comments during the last reporting season and relatively strong macro data. Moreover, C&I loans even decreased by 0.3% since the election (as of 02 Feb). Current loan growth of the segment is just 5.4% yoy, the lowest level since 2011.

Consumer loan growth YoY rate is currently 6.9% vs 7.1% year ago. There is some pullback in loan growth rates since the end of summer, but they still demonstrate healthy pace of expansion rate. Significant part of deceleration growth is associated with credit cards segment, but we think that it is temporarily phenomenon. Looking ahead into 2017, we are convinced that consumer will be the key driver of total loan portfolio growth due to healthy employment trends and relatively high wage growth and still low debt service ratios despite growing rates.

President Trump started to fulfill his campaign promises from the first days after the inauguration. As for financial regulation, he has already signed several executive orders to reduce regulation burdens in financial industry. One of these orders is designed to roll back Dodd Frank, which was fiercely criticized by Trump during his election campaign. But we still disagree that deregulation will be a game changer for financial industry in midterm. Definitely, dividends and buybacks will rise from current levels, but it is not structural shift for future operational results as industry is old, liquidity is high and there are few opportunities for reinvestment of released capital. The clear winners of deregulation should be relatively small banks because of bipartisan support of such initiatives.

We think that uncertainty about fiscal easing will not be solved quickly and it will be negative catalyst for US banking sector. At least, we don’t expect noticeable credit quality improvement in corporate sector. Of course, we should see more easing of credit standards when it is clarified language of tax reform or deregulation and other initiatives of the President, and then it should transform in credit growth, but we don’t expect that loans will significantly accelerate from current levels. Moreover, there is risk that it first will get worse to become better then.

We remain cautious on US banks at these levels and recommend to sell them vs S&P 500 index in 1H2017. From our point of view, too much optimism was incorporated in banking stock prices. We think that at the moment market tries to focus only on the positive sides of the Trump's initiatives and it doesn't carefully consider potential risks. Moreover, European political calendar may also be a risk for US banks.

In February EU Banks decreased by 2% (the closing price on Friday, February 24) vs +2.7% of STOXX 600 Index. European banks fell for the first time in the last 5 months. EU banks underperform despite relatively strong reporting season, but key reason is strong outperformance during previous 4 months, when SX7P index added 23.6% vs 5% of STOXX 600 index. Current correction looks quite logical event, taking into account busy political calendar and relatively high valuations of EU banks.

Current absolute February SX7P performance is -0.4 St. Dev from the mean and this result is in the bottom 30% absolute monthly performance of SX7P since the index inception. Relative underperformance of SX7P vs STOXX 600 index in February was -4.7% and it is in the bottom 9% relative monthly performance vs STOXX 600 (-1.3StD).

4Q reporting season was slightly positive for European banks with around 50% of banks beating estimates. But median surprise was around 0. Estimates were revised up, median banks EPS increased +0.2% MoM for EPS estimates of 2017. Three-month revision was higher, +1.6%, but we think that main driver of this review was rates dynamics which increased significantly since US election. Currently, median EPS is estimated to grow by around 10% for every of next 3 years. It seems that we saw trough in EU banks earnings due to ongoing steady economy growth, positive dynamics of yields and positive movement of profit for most EU sectors. However, market reaction on the earnings season was negative and SX7P index currently decreased by 2.5% since the beginning of 4Q16 reporting despite generally positive quarterly statements.

Macro momentum in EU remains but we don’t think that it will improve significantly near term as surprise index is still near the highest level for 2 years, but it slightly decreased from end-January levels. Sluggish but steady economic expansion in the euro area continues for fifteenth consecutive quarter, driven by domestic demand due to supporting monetary policy. Recent evidence suggests that the GDP growth even accelerated a bit. At least, GDP forecasts for 2017 and 2018 years increased by 7 bps (to 1.55%) and 1 bps (to 1.57%), respectively, during the last months, despite miss of GDP 4Q16.

Despite ongoing macro recovery, loan growth remains very weak and key current driver of banking stocks is growth of yields. EU corporate loan growth accelerated to 0.6% yoy in December, but it was just fourth consecutive month of positive growth. Whereas, EU loans to households increased by 1.9% yoy December, that roughly corresponds to the average level of the last year. But upturn in rates stopped recently and it is unlikely that they will begin to rise again near term.

Banks multipliers also significantly increase during previous months as EPS estimates remained relatively unchanged. Median P/E for EPS 2017E is currently 11.4x. Median P/E for EPS 2018E is presently 10.3x. It is close to 5yr averages and banks P/E discount to broad market is also in line with its long-tem averages, but current banks ROE discount to broad market ROE is much wider than it was before this cycle.

Key risks for European banks remain political events with Dutch elections in March, France presidential elections in April-May, German Federal elections in September and German parliament election in October. Moreover, there is a risk of early elections in Italy. And recently potential problems with Greece resurfaced again. Of course, election victory of populist parties still looks unlikely, but investors don’t want to risk in this uncertainty environment mindful of the unexpected results US election and Brexit vote.

Taking into account busy political calendar and relatively high valuations, we are cautious on EU banks near term. Of course, accommodative monetary policy of ECB should help the European economy to go through upcoming political events without significant losses. But currently we see value only in Italian banks among European banking sector, however it doesn’t mean that they will grow when other EU banks go down.

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