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Banking Sector Report - November 2016

In November US banks showed skyrocketing growth due to very optimistic expectations of pro-banking policy of the new President. The index finally managed to break strong resistance, defined by the top of the long-term sideways channel, within which it has been trading since mid-2013. BKX index added 16.7 % during November vs. 4.1% of SPX (the closing price on November 25). Even underperformers were able to add more than 9% over the past month. Outperformers were SVB Financial (SIVB), Signature Bank (SBNY) and Regions Financial (RF), each of which increased by more than 25%. With such a rapid spurt banks finally were able to show positive YTD performance. And it is possible that momentum could last through the year end, despite rally is not supported by fundamentals yet.

Market responded quite optimistic at the unexpected Trump’s victory, especially for banking stocks. Bank stocks have shown strong growth, reflecting expectations of possible higher GDP growth, lower taxation, higher interest rates and less regulation. We agree that many of the new President's initiatives may have a very positive impact on the operating results of banks, but we still have a lot of questions about the extent of this positive impact and possible negative aspects of a number of campaign promises of the New President. Moreover, there is still high level of uncertainty as to when these initiatives can be implemented. Most of the initiatives will begin to be implemented not earlier than in a year. Also do not forget that many initiatives can have side effects and natural limitations on the economy and the budget.

US macro gave us a mixed picture. On the one hand, there is robust data of financial health of the consumer - strong labor market, high consumer confidence and still low debt service ratios. On the other hand, lending standards for C&I and CRE segments continue to tighten for several consecutive quarters and it is to some extent a red flag for us as tightening standards is a relatively good indicator of possible future deterioration in loans quality in these segments. Taking into account relatively weak macroeconomic indicators in the segments, the main question for us is whether Trump’s proposals have enough time to improve these trends.

This is not surprising that banks positively reacted to rates growth, as between banks prices and the dynamics of rates recently seen a high correlation. That was also followed by a small revision of profit forecasts. But there are a lot of questions to this movement of the market. Well, yield curve became much steeper compared to situation a month ago. But compared to the beginning of the year, interest rates (long end of the curve) remained almost unchanged, while the banks prices have already increased on average by 16%. Multipliers are also much higher than post-crisis averages. We agree that Trump’s proposals could be very positive for banks, but, at least, long-term trends have been unchanged yet and it is unclear when it is changed. It is also worth noting that the possible positive changes from these proposals in the best case will occur at the end of next year. And we do not believe that the current positive effect on the banks prices from possible growth of EPS on tax cuts, reducing regulation is more than a negative effect on the valuation from the growth of rates. In such conditions, from our point of view, it is better to refrain from purchases. Of course, if all the positive proposals of the new President will be quickly implemented, we will see the banking stocks much higher. But we think that it is justified to wait for evidence of structural improvement in macro trends to buy stocks.

European banks also demonstrated positive dynamics in the last month: SX7P index added 2.8% vs. 0.5% of STOXX 600 Index. But within the group dynamics were much more fragmented. Leaders significantly outperform laggards. Outperformers were Barclays (BARC LN), UBS (UBSG VX) and Deutsche Bank (DBK GY), each of which increased by more than 10%. In turn, laggards have decreased by more than 20% and almost all of them are Italian banks. Such divergent dynamics is not surprising, given a number of different drivers. Positive influence was exerted by the relatively good reporting season (almost 90% of positive EPS surprises) and Trump related optimism, including steepening yield curves in Europe. The negativity is primarily associated with the Italian referendum which will take place on 4 December. Uncertainty is very high, as a “No” vote could run many scenarios, most of which will have a significant negative impact on both fundamentals and sentiment.

Most of the European banks beat EPS estimates with a median positive surprise of 12.9% that, in general, consistent with what we observed during the last US reporting season. More than 88% of reporting banks from our sample showed positive EPS surprises. From the median EPS surprise point of view, it was the best quarter since Q1 2010. Moreover, banks also showed positive revenue surprises, +1.1% median, what is highly valuable in the current low rate environment, particularly as most other European sectors showed negative surprises on the revenue side. It was better quarter than it had been expected, but it wasn’t the good one. From our point of view, the main reason of so high positive surprise was huge negative revision of EPS estimates during both quarter and year. 

Despite the fact that the centre stage in Europe is now focused on the political developments, primarily to the Italian referendum and Trump-election, macroeconomic data also do not lose their importance. Flash data of GDP growth in 3Q 2016 was in line for overall euro area. But better than estimates results were demonstrated by periphery countries, including Italy. Of course, relatively good data always pose the question regarding its sustainability. We do not see serious threats to economic growth in Europe, with the exception of political uncertainty. Recent employment data, collected in November, also confirms that the European economy continues to slowly but surely grow. The falling Euro, still low energy prices and expectations of accelerating growth in the U.S. should have a positive impact on the growth of the European economy next year, despite a busy political calendar.

The main political event of the end of the year, from our point of view, is the referendum on constitutional reform in Italy. In the next 1.5 years we are waiting for the marathon of political events in Europe – elections in France, Germany, Netherlands and Italy. However, we could see Italian elections earlier. Polls and predictive models still suggest that the response to the referendum will likely be "No". But the share of undecided voters is also high. The “No” answer will probably delay further many of the necessary reforms, especially in banking sector. Future situation also may be complicated by the possible resignation of Prime Minister Matteo Renzi.

From our point of view, even relatively short-term negative sentiment on all Italian assets after the “No” vote could have more long-term and serious negative consequences for Italian banks, considering their weak financial condition at the moment. But right now, we recommend to refrain from any action with Italian banks in case of “No” vote, as very low multipliers and serious underperformance YTD are balanced by possible outcomes of the most negative scenario.

It is obvious that the most positive outcome for both Italian and European banks will be the approval of the reform. It would mean the confirmation of the trust to Renzi’s government, which will continue to realize implementation of banking reform and stimulation of economic growth. It would be the most bullish outcome, given the current underperformance of Italian banks. In case of “Yes” vote we strongly recommend to buy Italian banking stocks, as we don’t think that rally in this case will be short-lived.

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