HomeResearch and NewsBanking Sector Report - July 2018
Mikhail Zavaraev CFA, Senior Analyst
Report

Banking Sector Report - July 2018

EXECUTIVE SUMMARY

After two consecutive months of underperformance US banks finally outperformed S&P 500 index in July due to positive perception of the earnings season. In July, US banks increased by 4.9% MoM vs +3.6% of SPX index. But on the YTD basis, banks still underperformed the broad market by 3.1% as of end-July. Absolute July performance on MoM basis was +0.6 StD from the mean and it is in the top 29% of the absolute MoM performance of BKX index. Relative July performance was +1.22% MoM, it is +0.26 StD from the mean and it is in the top 39% of relative MoM performance vs SPX. July is a relatively strong month, from the historical performance point of view, with positive absolute MoM dynamics in 18 cases over the past 27 years. But this year, US banks demonstrated the strongest July dynamics over the last 5 years.

Dynamics within the sector was driven by quarterly results. So, the most spectacular performance was demonstrated by the banks with the strongest quarterly results. But it should be noted that the variance of individual banks dynamics was higher than usual.

US banks again reported strong figures, from EPS surprises point of view. 21 out of 24 of our group banks demonstrated positive surprises, the second highest share for the second quarter over last 12 years. Median EPS surprise for our group of banks was +3.3%, slightly lower than median quarterly surprise of 4.4% over the last 12 years. In turn, revenue surprises weren’t so strong. Just half of our group of banks demonstrated positive surprise with the median figure of +0.2%, the second quarter in a row over the past 6 quarters when positive revenue surprises are not significantly higher than negative ones. However, market perception of the results was positive – BKX index increased by 3.2% since the start of the earnings season till the end of July while S&P 500 index added just +0.6% over the same time. Also, banks markedly revised up both quarterly and yearly EPS estimates QTD in the third quarter even despite significant growth of estimates at the beginning of the year because of incorporation of tax reform impact. Median growth of the 3rd quarter consensus EPS estimate was +0.5% QTD, while median growth of FY 2018 and 2019 EPS were +1.2% and +0.9%, respectively.

Total net interest income of BKX index members increased by 1.8% qoq or +5.4% yoy in 2Q18 vs +0.7% qoq or +5.3% yoy in 1Q18 and +1.6% qoq or +7.1% yoy in 2Q17. Key drivers of qoq NII growth were NIM growth and higher day count in the quarter. However, just 8 out of 24 BKX members showed positive surprise on NII in 2Q18 with median figure of -0.6%. In turn, NIM was better than estimates with median positive surprise for BKX index members of 0.8 bps in absolute terms. NIM of 16 out of 24 BKX members exceeded consensus forecasts. Median NIM of BKX index members increased by 1.5 bps qoq and 15 bps yoy vs +6.5 bps qoq and +22 bps yoy in 1Q18 and +8.5 bps qoq and +14.5 bps yoy in 2Q17. 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 current deposit beta and 27% of cumulative one since the end of 2016. Cumulative deposit beta is still markedly lower than it was in the previous cycles, but the last move doesn’t look too optimistic for US banks. Moreover, more and more banks note higher deposit competition and it implies further growth of deposit costs. First of all, costs of corporate and wealth deposits are growing while the growth of costs of retail deposits remains restricted.

Total non-interest revenue of BKX index members increased by 0.3% yoy and declined by 2.7% qoq in 2Q18. However, the median growth of non-II of BKX index members in 2Q18 was +0.6% qoq and +3.2% yoy. 14 out of 24 BKX index members demonstrated positive surprise on non-II with median surprise figure of +0.4%. Capital markets revenues and IB fees were relatively strong while other components of non-II remain weak, especially mortgage revenues which should be weak further taking into account QTD dynamics of mortgage applications and spreads.

Overall, operating trends of US banks remain strong with better capital markets, good cost control, high quality of the loan portfolio, accelerating of loan growth and ample capital levels, but it seems that NIM is no longer the main driver of EPS even despite it was slightly better than estimates in 2Q18 as both deposits and total funding costs rose significantly in the last quarter. Loan growth isn’t already a headwind for the industry due to acceleration of C&I loans because of high level of M&A activity but we don’t expect that it could fully mitigate the negative impact of accelerating growth of deposit beta in the coming quarters. Street estimates increased after the earnings season but currently, we do not see much potential for growth of profits without further acceleration of loan portfolio growth and a steeper yield curve. Deregulation could have a positive impact on the bottom line of US banks but the process takes time. So, we believe that it is necessary to be selective and invest in banks with high asset sensitivity, good deposit franchise, high level of excessive capital and good cost control. It should be also noted that, at the moment banks aren’t expensive, from historic point of view, trading with -0.6-0.7 std on P/E CY and -0.1-0.3 std on P/E NY (on the basis of samples from 2000 and 2010 yrs to current moment). As for relative to S&P 500, banks are currently trading at -0.8 and -0.9 std from the sample mean (2000-current moment) for P/E CY and P/E NY, respectively. It should also support the quotes. Our top peaks remain Bank of America (BAC), JP Morgan Chase (JPM), Morgan Stanley (MS), Comerica (CMA) and Zions Bancorporation (ZION).

July was the second month in a row of outperformance of EU banks vs the broad market index after three consecutive months of negative relative dynamics. In July, SX7P index increased by 4.3% MoM vs +3.1% MoM of STOXX 600 index. Absolute July performance of SX7P was +0.6 std from the mean and this result is in the top 23% of absolute monthly performance of SX7P since the index inception. So, relative monthly performance was +0.4 std and this result is in the top 30% of relative monthly performance. But SX7P still significantly underperformed STOXX 600 as the end of July, -9.2% ytd.

Dynamics within the sector wasn’t uniform and remained too volatile, not least because of the start of the reporting season. The key outperformer was Deutsche Bank which added +21.3% MoM in July due to better than expected net income in 2Q18. The quality of the beat was relatively low but it was enough to slightly change the market sentiment given significant underperformance of DBK in the first half of the year (still -29.5% ytd).

Start of 2Q18 earnings season of European banks was encouraging with significant growth of profits, better credit quality but still anemic loan growth. Nevertheless, weak macro figures in 1H18, trade war threats, political uncertainty and, as a result, a significant drop in European yields along the curve, all this continues to have a negative impact on the dynamics of European banks. However, despite economic data published in July was relatively soft with misses on retail sales and PMI, the indices of economic surprises continued the growth, which began in June after being at almost 7-yr low for around 1.5 months due to better figures of unemployment, industrial production, and consumer confidence were better than estimates. In any case, the key driver for future profits of EU banks, rate hikes, is still far in time from us. July ECB meeting brought little news on this matter. Both the introductory statement and policy rates were left unchanged. Questions and answers section of the press conference also didn’t throw the light on the key insights and details of the further monetary policy such as additional details on timing of the first rate hike and reinvestment policy of the APP. The sell-off of recent months created a good buying opportunity for some banks in Europe but we still prefer US banks to EU financial institutions primarily because EU banks don’t look cheaper than US peers from the historical average valuations point of view.

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