EXECUTIVE SUMMARY

US banks went higher in August after relatively flat dynamics in three previous months following very volatile first four months of the year.. But banks underperformed the broad market significantly again, the 4^th month in a row and the 7^th month of weaker dynamics over last 8. Thus, BKX index increased by 3% MoM in August vs +7% MoM of SPX index. Absolute performance on MoM basis was 0.3 std from the mean and it is in the top 36% of absolute MoM performance of BKX index. Relative August performance was negative, -3.8% MoM. It is -0.8 std from the mean and it is in the bottom 15% of relative MoM performance vs SPX index since 1992. It was by a wide margin the worst first eight months of the year on both absolute and especially relative basis in BKX index history.

Key outperformers in August were consumer finance companies as quality characteristics of consumer loans remains resilient while employment dynamics is encouraging. The best performer was SIVB, among the few growth stories in US banking sector, which focuses on Tech sector. NYCB was the key underperformer because of high CRE concentration, especially in NY, which fundamentals have deteriorated significantly.

Macro data published in August were neutral, from our point of view, but forecasts were slightly improved recently despite high-frequency data have started to point to recovery deceleration. Notwithstanding, it is faster than feared 1 quarter ago. But no additional fiscal support after the previous program ended creates new risks for further economic growth, even taking into account slowing spread of the virus in majority states in August. New Fed strategy which targets inflation that averages 2 percent over time implies, from our point of view, that key rates will remain near zero even longer than previously expected. However, estimates were revised slightly up. Thus, median growth of 3Q20 EPS of BKX index members was +1.4% MoM in August, after it increased by 7.5% during 2Q20 earnings season while EPS 20E added 1% MoM and EPS 21E was flat.

Due to significant decline of EPS estimates ytd, banks is no more trading with discount to CY estimates but they are still undervalued to NY estimates and vs S&P 500. Thus, banks are trading at +1.0/+0.9 std on P/E CY and -0.5/-0.3 on P/E NY (on the basis of samples from 2000 and 2010 years to current moment) relative to historical averages (as of August 28). As for relative to S&P 500, banks are currently trading at -2.1 std and -2.2 std from the sample mean (2010-current moment) for P/E CY and P/E NY, respectively. On P/B, banks are trading at -1.5 std from the sample mean (2010-current moment) vs SPX at +2.5 std. Despite stocks are still trading at significant discount to S&P 500 index, we remain cautious on US banks given unprecedented decline of US economy in 1H20, still high level of uncertainty about the speed of US economic recovery, mixed 2Q20 results and rising risk related to the elections. Absence of outperformance of US banks vs SPX index during recent rally despite relatively high beta indicates that investors still prefer not to get involved with banks. So, we also remain on the sidelines until we see first signs of fundamentals improvement. But we have already been more positive about the sector perspectives than we were 2-3 months ago.

EU banks markedly rose in August after significant decline in July. But their dynamics remains very weak. SX7P index ended 5 out of 8 months of 2020 in the red zone. On absolute basis, SX7P index went up by 4% MoM in August or +0.6 std from the mean and this result is in the top 26% of absolute monthly performance of SX7P since index inception. Relative monthly performance was +1.1% MoM or +0.4 std and it is in the top 31% of relative monthly performance. Despite weak relative dynamics in two previous years when SX7P index underperformed the broad market by 12.1% and 17.1% in 2018 and 2017, respectively, EU banks continue to lag broad market considerably. On ytd basis, SX7P underperformed by 26.7% as the end of August.

Dynamics of European banks was relatively uniform with more than 80% of SX7P index members ended August in the green zone. The key driver of positive dynamics was earnings season. Notwithstanding, the best performer in August, Banco Sabadell, which added 17% MoM, had reported weaker figures but it still remained one of the worst performers ytd and its growth was caused by relief rally.

European banks reported markedly better figures in 2Q20 with positive EPS and revenue surprises for majority of SX7P index members even despite significant growth of provisions for the second consecutive quarter. Thus, 26 out of 32 banks from SX7P index for which estimates were available reported positive surprises on EPS. But earnings momentum continued to worsen with median decline of operating profit of more than 40% yoy for the second consecutive quarter. Revenue declined by 3.4% yoy driven by both NII and fees which were unexpectedly resilient in 1Q20. Decline was broad-based and it seems that negative dynamics will persist in 2H20. Unsurprisingly, market perception of the results was slightly negative. Thus, median 1-day performance of SX7P index members around the earnings date was -0.2%.

The key driver of negative NI dynamics was an explosive growth of provision expense, which will remain elevated in the nearest quarters given the depth of economic slowdown. So, median ROE of EU banks declined by 158 bps qoq or -335 bps yoy to 5.1%, the lowest figure since 4Q14. Due to positive EPS and revenue surprises as well as strong cost control, expectations stopped being revised down. Thus, median decline of FY2020 revenue estimates is 4.6% ytd but +0.9% qtd, implying decline of 13.6% yoy. As of FY2021 revenue estimates, median decline is 7% ytd but +0.7% qtd, implying growth of +0.7% yoy in 2021. Median EPS 2020 decline is -59.2% ytd but +1.6% qtd while median EPS 2021 decline is -44.7% ytd or +1.0% qtd.

Despite credit quality of European banks remained solid so far, provisions skyrocketed by 280% yoy in 2Q20 after growth of 196% yoy in 1Q20, the 5^th consecutive quarter of yoy growth after 27 consecutive quarters of lower provisions. It wasn’t surprising given meltdown of EU economy in 1H20, but forecasts were relatively flat in 3Q20. And it is hardly to expect that provisions will continue their skyrocketing growth if we don’t see new lockdowns because of the second wave of the pandemic. Thus, median growth of provision expense estimates of BKX index members was 175% ytd but flat qtd and +74% ytd / +1.0% qtd for 2020 and 2021 years, respectively. In turn, median NPLs ratio increased by 4 bps qoq or just +13 bps yoy to 2.8% in 2Q20. So, coverage ratio increased by 2.4% qoq or +3.1% yoy in absolute terms to 61.7%, the highest level over more than 10 years.

Recovery of EU economy has decelerated recently despite surprisingly fast response by ECB and the governments in the form of significant both fiscal and monetary stimuli. So, economic projections were improved recently while 2Q20 earnings season was markedly better than feared. But better figures don’t mean that results were strong. On the contrary, they were quite mediocre and we expect that fundamentals will remain relatively weak in the nearest 3-4 quarters. Notwithstanding, we believe that EU banks have already tested the bottom given current economic estimates. From the other hand, EU banks is no more trading with discount to historical averages while discount to US peers is much lower than usually. Thus, premium to historical averages is +4% (+0.2 std at the moment from mean P/E NY of SX7P index members, sample from 2010 to the present) but discount to US peers (on median P/E NY of BKX index vs SX7P index) is just 15.5% at the moment vs average since 2010 of 20.8%, out of synch with reality, from our point of view, given higher risks associated with EU banks which have not fully recovered from the previous crisis yet. So, we continue prefer US banks to EU ones at the moment.

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09 August 2020, Arbat Capital

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