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Banking Sector Report - November 2018

EXECUTIVE SUMMARY

US banks outperformed the broad market on MoM basis second month in a row, after two consecutive months of significant underperformance. Thus, banks increased markedly in absolute terms in November. However, BKX index underperformed S&P 500 index in four months over the last 7. In November, US banks increased by 2.7% MoM vs +1.8% of SPX index. On the YTD basis, banks still underperformed the broad market significantly by 7.8% as of end-November. Absolute November performance on MoM basis was +0.3 StD from the mean and it is in the top 38% of the absolute MoM performance of BKX index. Relative November performance was 0.9% MoM, it is +0.2 StD from the mean and it is in the top 41% of relative MoM performance vs SPX.

Dynamics within the sector was relatively uniform, just 8 out of 34 banks from our sample showed negative performance. The key underperformer was Goldman Sachs which decreased by 15% MoM in absolute terms on news about Malaysia 1MDB Wealth Fund probe.

Despite outperformance in November, banks continue trading with significant discount to both SPX and historical averages. Currently, multipliers of US banks are just 7% higher than levels of early 2016, from which banking rally started. Thus, banks are undoubtedly cheap, trading with -1.3/-1.4 std from the mean on P/E CY and -1.3/-1.6 std from the mean on P/E NY (on the basis of samples from 2000 and 2010 yrs to current moment, respectively). As for relative to S&P 500 basis, banks are currently trading at -1.7 and -1.8 std from the sample mean (2010-current moment) for P/E CY and P/E NY, respectively. Deep discount to S&P 500 index was almost not reduced in November despite the strong earnings season again, 19 out of 24 of our group banks demonstrated positive surprises on 3Q18 EPS. FY2018/2019 EPS estimates increased by 14.5% and 13.4% YTD due to positive effect of the tax reform but its effect will inevitable decline in 2019. EPS growth of BKX index members in 2019 is estimated at around 9% yoy. Loan growth keeps being relatively weak even despite GDP growth remains solid while NIM growth will inevitably slow as deposit beta has accelerated. Also, growing European uncertainties don’t positively impact on quotes of US banks. Despite the late cycle and all European risks, we still have positive view on US banks but we are convinced that 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. Our top peaks remain Bank of America (BAC), JP Morgan Chase (JPM), Morgan Stanley (MS), Comerica (CMA) and Zions Bancorporation (ZION) and Wells Fargo (WFC).

November FOMC meeting, which were held in the first decade of the month, didn’t bring any significant news. The fed funds rate target range were left unchanged, as widely expected. In support of nonevent meeting, the probability of rate hike on the December meeting remained unchanged at approximately 80% after November one, the level near which it was being within the last 2.5 months. Also, the wording of the statement changed slightly, reflecting the recent macro data. Thus, it was noted that unemployment had declined (“stayed low” previously) and that growth of business fixed investment had moderated (from “grown strongly”). Given the strong macro figures in October and November, it is hard to expect that the Fed will not hike the rate in December. Notwithstanding, it is more important for both banks and the broad market how many rate hikes we will see in the next year given negative effects of the trade wars, fading positive effects of the tax reform, decelerating growth of business fixed investment and increased pressure of relatively high debt burden on US corporations because of rising rates. We expect three more rate hikes in the next year and 5 more in total from today until the hike cycle will be ended.

Loan growth still remains weak. According to the Fed H8 data, total loans increased by 4.4% yoy (as of November 14), slightly accelerating from +3.5% yoy growth demonstrated 1 year ago, but it is the same as it was in the last several months, no acceleration in loan growth rates, which is so necessary for quotes to rise. Acceleration in C&I segment was offset by deceleration of consumer loan growth.

After slight outperformance in September, European banks decreased the second month in a row. In turn, it outperformed the broad market on relative basis in November. But, SX7P index continues to significantly underperform broad market index YTD, -15.1%. In result, SX7P index is still near the two-year low, even lower than the pre-election level of the 2016 year. Absolute November performance of SX7P was -0.4% MoM or -0.1 std from the mean and this result is in the bottom 40% of absolute monthly performance of SX7P since the index inception. So, relative monthly performance was +0.8% MoM or +0.3 std and it is in the top 36% of relative monthly performance.

The key underperformer was CYBG PLC which decreased by 23.7% MoM in November because of weak preliminary results of 2018 year with negative NIM outlook and higher capital requirements. Also, weak dynamics were shown by other UK banks because of rising risks related to Brexit.  In turn, Standard Chartered showed the best performance as approximately 90% of revenues generated outside Europe.

European financial institutions continue to suffer from uncertainties related to Brexit, Italian budget and so on. In result, SX7P index underperformed the broad market by 15% ytd, trading near the lowest level in more than 2 years. Valuations are even lower, with forward P/E multipliers near 6-7 year lows despite solid growth of both EU economy and banking revenues/profits, at least until recently. But the situation has already begun to change with weak macro data and missed GDP growth in 3Q18. 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). We have already seen how a prolonged period of political uncertainty could adversely impact on an economy with negative QoQ Italian GDP growth in 3Q18 and risk of further unfavorable GDP dynamics in coming quarters. Currently, EU banks look undoubtedly attractive, from only valuations point of view, trading with a significant discount to historical averages (-16% or -1.1 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. From the other hand, we have no doubts that, as usual, the market will begin to take a lead from a positive outcome of an event long before than there will be news about it. So, we recommend fill 50% of wishful share of UK or/and Italian banks in the portfolio currently. Our top picks in these countries are UniCredit, Lloyds and Barclays. The filling of other 50% of position should be event driven (a positive outcome of Brexit/Italian budget negotiations). In case of negative outcome of the event, it is better to close the initial long position as price decline could be significant even despite negative price dynamics previously. Also, a good hedge strategy for this case, from our point of view, is to cover the long position by put options but it is not a free strategy given the recent growth of volatility.


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