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Banking Sector Report - October 2018


US banks outperformed the broad market on MoM basis, after two consecutive months of underperformance, but banks declined significantly in absolute terms in October. Moreover, BKX index underperformed S&P 500 index in four months over the last 6. In October, US banks decreased by 5.7% MoM vs -6.9% of SPX index. On the YTD basis, banks still underperformed the broad market significantly by 8.6% as of end-October. Absolute October performance on MoM basis was -1 StD from the mean and it is in the bottom 13% of the absolute MoM performance of BKX index. Relative October performance was +1.3% MoM, it is +0.3 StD from the mean and it is in the top 33% of relative MoM performance vs SPX. It is the worst performance of BKX index in October on absolute basis over the last 9 years.

Dynamics within the sector was relatively uniform, just four out of 34 banks from our sample showed positive performance. The key driver of US banks was the earnings season and banks with weak figures decreased significantly.

US banks again reported strong figures, from EPS surprises point of view. 19 out of 24 of our group banks demonstrated positive surprises, the lowest figure over the last 5 quarters but it was higher than median share of positive quarterly surprises over the last 12 years. Median EPS surprise for our group of banks was +2.8%, markedly lower than median quarterly surprise of 4.4% over the last 12 years. In turn, revenue surprises weren’t so good. Just 13 companies of our group of banks demonstrated positive surprise with median figure of +0.2%, the third quarter in a row over the past 7 quarters when positive revenue surprises are not significantly higher than negative ones. So, market perception of the results was negative – BKX index decreased by 2.4% since the start of the earnings season till the end of October while S&P 500 index lost just 0.6% over the same time. Also, banks revised down quarterly EPS estimates while FY 2018 and 2019 estimates were revised up. Median growth of 4Q 2018 consensus EPS estimate was -0.6% QTD, while median growth of FY 2018 and 2019 EPS were +0.6% QTD and +0.1% QTD, respectively.

The main attention was focused on NIM, deposit betas and loan growth. Median cost of interest-bearing liabilities on qoq basis increased more than yield of earning assets, for the second quarter in a row. It is not a good sign for banks, but loan beta is still higher than deposits beta and it leaves the room for further growth of NIM. In result, still low deposit beta a little cooled the ardor of the pessimists even despite outflow of non-interest bearing deposits. Banks continue to note rising deposit competition but the situation varies from bank to bank and small banks have fewer opportunities to keep deposit costs low than large ones with very good deposit franchise and a large number of offices across the country. Nevertheless, we do not expect a significant acceleration of incremental deposit beta growth in the near future across the overall industry and we don’t think that significant growth of deposit beta in 2Q18 is a start of the trend given still low loan-to-deposit ratios and relatively low loan growth. Of course, both cumulative beta and incremental one will go up further but we don’t see significant reasons for growth of cumulative deposit beta higher than 50%, at least at the current moment.

Loan growth remains weak. Median growth of EOP loans of BKX index members was +1.3% qoq and +1.9% yoy. As of average loans, median growth was +0.4% qoq and +2.7 % yoy (the lowest growth rate in 6 years). According to the Fed H8 data, total loans increased by 4.4% yoy (as of October 10), slightly accelerating from +3.5% yoy growth demonstrated 1 year ago, but it seems that decelerating loan growth is behind us, at least for a while. But, unfortunately, marked acceleration of loan growth is also not on the agenda.

Overall, operating trends of US banks remain strong with better capital markets, 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, loan growth is relatively weak even despite GDP growth remains solid; NIM growth is inevitably slowing as deposit beta has accelerated; uncertainty and risks increased. FY2018 EPS slightly increased since the start of the earnings season due to high number of positive surprises but FY2019 EPS estimates were roughly flat. However, despite all negative factors median yoy EPS growth of BKX index members in 2019 is estimated at around 9% yoy, which is quite good for the current stage of the business cycle. FY2018/2019 EPS estimates increased by 14.5% and 13.4% YTD, respectively while BKX index decreased by 7.5% YTD vs +1.4% of SPX index. So, banks are cheap vs SPX, trading with -1.6/-1.7 std on P/E CY and -1.3/-1.6 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 -1.3 and -1.4 std from the sample mean (2000-current moment) for P/E CY and P/E NY, respectively. But we think 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). Also, we added in the list Wells Fargo (WFC) as two last quarterly reports were encouraging while regulatory headwinds gradually disappear.

After slight outperformance in September, European banks again decreased significantly. Thus, SX7P index continues to underperform broad market index YTD, -15.8%. In result, SX7P index is at two-year low, even lower than the pre-election level of the 2016 year. Absolute October performance of SX7P was -8.2% MoM or -1.3 std from the mean and this result is in the bottom 10% of absolute monthly performance of SX7P since the index inception. So, relative monthly performance was -2.7% MoM or -0.7 std and it is in the bottom 19% of relative monthly performance.

Dynamics within the sector was relatively uniform with just 2 banks with positive monthly performance. The key underperformer again was Danske bank which decreased by more than 25% in October after it decreased by more than 10% in September. In result, Danske lost 1/3 of its market value over the last two months. The uncertainty with future fines is still very high and investors don’t still want to buy the stock even despite strong capital position, high ROE, good efficiency of the business and a deep discount to peers.

The start of 3Q18 earnings season of European banks wasn’t as encouraging as it was at the end of the 2nd quarter. Notwithstanding, EU banks continue to demonstrate solid profit growth due to improving credit quality. Revenue growth remains anemic what is not surprising given negative rate environment. Better credit quality could remain the key driver of both profit growth and rising market cap under the condition of not deteriorating economic situation in what, however, there is some doubt at the moment given recent macro data. Initial estimate of 3Q18 real GDP growth of +0.2% QoQ was significantly lower than both Bloomberg consensus and growth of +0.4% QoQ showed in 2Q18 and 1Q18. Composite PMI, which is well correlated with GDP growth, decreased again in October after decline in September. The figure decreased on MoM basis in 7 months out of last 10. ECB also noted that incoming information was weaker than expected recently but it still assessed the expansion of Euro Area economy as broad-based and risks as broadly balanced despite rising uncertainty related to Italian budget and trade wars. But EU banks remain one of the cheapest sectors in EU, trading with estimated P/E 18/19 at 9.2x and 8.4x, respectively, the lowest figure over more than 2 years suggesting an attractive risk-reward opportunity, from our point of view.  We don’t rule out that prices may go down further but it will be an opportunity for us to increase the share of EU banks in the portfolio.

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