HomeResearch and NewsBanking Sector Report - September 2017
Mikhail Zavaraev CFA, Senior Analyst
Report

Banking Sector Report - September 2017

EXECUTIVE SUMMARY

In September US Banks (BKX index) sharply increased by 6.8% MoM vs +1.9% of S&P 500 Index. But SPX continues to outperform financial sector YTD: +12.5% vs +8.1% of BKX index, however this gap decreased significantly during the last month. Absolute September performance was +0.9 std from the mean monthly performance. This result is in the top 15% of absolute monthly performance of BKX Index. Relative monthly outperformance vs SPX index in September was +4.7% and it is +1.05 std from the mean monthly performance. This result is in the top 12% of relative performance of BKX index vs SPX.

The key drivers of banking quotes were more hawkish than expected September Fed meeting, tax reform hopes and expectations of deregulation of financial sector. In result, all banks from our sample except SBNY showed positive dynamics in September. The most impressive growth was demonstrated by laggards of previous months, those which are more sensitive to one or both of rising rates and lower taxes. Despite there are few details of coming reforms currently, the market is try to buy the rumors.

Macro data was strong in September despite negative effect of the recent hurricanes. Citi economic surprise index continued to go up and it returned on the positive territory in recent days, for the first time since April. 2Q17 GDP was revised up by 0.1% bps in absolute terms to 3.1% qoq annualized. Manufacturing remains in good shape, with majority of macro indicators above expectations in the last month. ISM manufacturing index increased by 2.3 pts MoM to 58.8 pts in August vs expectations of 56.5 pts. It is the highest level of the index in 6 years and it is just 2.6 pts below 30-yr high, signaling continuation of solid expansion in US manufacturing sector. Employment data was relatively weak in August but, from our point of view, it is temporary weakness because of negative impact of the hurricanes. Nonfarm payrolls increased by 156k in August, missing estimates of 180k. July’s figure was revised down from 209k to 189k. Unemployment ratios increased from 4.3% in July to 4.4% in August. Overall, macro remains broadly supportive for US banks.

As was widely expected, the Fed announced at the September FOMC meeting that it would initiate the balance sheet normalization program in October and it left the federal funds rate unchanged. From our point of view, the Fed announcement was slightly hawkish than expectations, confirming a third rate hike in 2017 and three more hikes in 2018 despite relatively soft inflation data. Unsurprisingly, the long end of the curve significantly increased in September. Also, the probability of rate hike till the year end increased from 20% as start of September to more than 60% currently. 12 out of 16 FOMC members project a third rate hike in 2017. In turn, the ‘Dot plot’ implies two hikes (down from 3 hikes earlier) in 2019 and it is decreased long-term median estimate of fed funds rate from 3% to 2.75%. The committee upgraded 2017 GDP growth estimate from 2.2% to 2.4% and 2019 estimate from 1.9% to 2%. Both 2018 and long term projections were unchanged. Unemployment rate expectations were revised down by 10 bps in absolute terms for 2018 and 2019 years. Inflation expectations were basically unchanged. Overall, the FOMC meeting announcements are quite positive for US banking quotes as rates will probably continue to rise and yield curve will be steeper. Given still low beta, NIM will keep going up as well as EPS. 

The next key event, from our point of view, will be 3Q17 earnings season which for banks will begin on 12th October when quarterly reports will be presented by Citigroup and JP Morgan Chase. It should answer the question whether the situation continues to improve. On the one hand, some of major US banks updated guidance on capital markets revenues and it wasn’t optimistic. From the other hand, deposit betas still remains low, both 3Q17 EPS estimates and 3Q17 revenue estimates continue to rise vs the start of the year and it is not a typical dynamics for it (estimates are usually going down during a typical year).

Overall, the operating trends of US banks remain strong. Median growth of 3Q17 EPS consensus estimate of BKX members is +2.8% since the start of the year. Full year EPS estimates 2017 and 2018 also go up unlike the previous three years. The same is true for revenue estimates. We don’t expect high share of positive surprises during the coming earnings season because of ongoing relatively weak loan growth, declining trading and mortgage revenues on yoy basis. But EPS growth remains solid and there are opportunities for accelerating of banking profits growth due to deregulation and possible tax cuts. At least, we see positive perception of possible regulatory and tax reforms by investors and we do not exclude the continuation of the rally in banking shares in the near future as banks underperformed S&P 500 index in the current year.

In September EU Banks (SX7P index) increased by 4.8% MoM vs +3.8% of STOXX 600 Index. Banks outperformed broad based market index by 3.4% YTD. EU banks continue trading in the narrow sideway channel for more than 5 months (175-191 pts on the SX7P index). Absolute September performance of SX7P was +0.7 std from the mean and this result is in the top 21% of absolute monthly performance of SX7P since the index inception. Relative outperformance of SX7P vs STOXX 600 index in September was +1.0% and it is in the top 34% of relative monthly performance vs STOXX 600 (+0.7 std).

Dynamics of European banks wasn’t uniform in September. Brexit and Catalan referendum negatively impacted on British and Spanish banks, respectively. RBI continues to be among the best European performers due to solid 2Q17 results and expectations of further strong dynamics of operating results. BPER accelerated in the last month and it added more than 13% in September as valuations had become more attractive after relatively long period of underperformance.

Steady economic expansion in the euro area continues with GDP YoY growth higher than 2% and recent macro data indicates that it will remain solid in 2H2017. We don’t exclude some deceleration of growth of EU economy because of euro strengthening, but it will still remain supportive for quotes of European banks in near years. Along with ECB staff estimates, Eurozone GDP growth consensus was revised up by 10 bps for both 2017 (to 2.1% YoY) and 2018 (to 1.8% YoY) years during the last month. The key positives of the last figures are broad-based character of EU recovery and stable character of the current growth of economy. The dispersion of growth rates of EU members is near the lowest level in 20 years. 

The ECB left its key policy rates unchanged on the last meeting, which were held on 7th September. Also, there weren’t done any tapering decisions. Overall, it was widely expected outcome. However, Mario Draghi noted that “bulk of the decisions” would be taken on October meeting despite tightened financial conditions in euro area because of appreciation of the euro currency. It seems that the ECB will eventually announce in October that monthly asset purchases will be reduced from current €60 bn to €40 bn since January 2018. But key rates will “remain at their present levels for an extended period of time, and well past the horizon of our net asset purchases.” Further pace of monthly asset purchases, from our point of view, will depend on the incoming information, including inflation and volatility in the exchange rate.

So, we still think that it is too early to buy banks because of possible rising rates in future taking into account very strong outperformance of European banks in the last year. Of course, fundamentals will continue gradually improve but the short end of the curve will not change significantly until the key policy rates will eventually start to grow; low rate environment will persist for several more years; growth of long end is largely already priced in, from our point of view; valuations don’t look as reasonable as before; loan growth is still sluggish, especially in corporate segment while credit quality issues remains.

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