HomeResearch and NewsArbat Capital: Banking Sector Report - December 2020

Arbat Capital: Banking Sector Report - December 2020

EXECUTIVE SUMMARY

US banks rose significantly again in December, the third consecutive month of substantial outperformance after five months in a row of underperformance. Thus, BKX index rallied by 6.7% MTD (through December 24) vs +2.3% MTD of SPX index. Absolute performance was +0.9 std from the mean monthly performance and it is in the top 16% since index inception. Relative December performance was +4.4% MTD. It is +0.9 std from the mean monthly performance and it is in the top 14% of relative monthly performance vs SPX index since 1992. Despite significant outperformance in three recent months, during which BKX index outperformed the broad market by 20%, it still underperformed SPX index by 26% ytd and it is the second worst year of relative performance in BKX index history.

Majority of US banks went up in December but the dynamics of BKX index members weren’t uniform, even despite it was driven by industry related factors such as buybacks ban lifting. So, the key outperformers increased by 15-20% MTD while AXP and NTRS decreased by 1.0% MTD and 1.6% MTD, respectively.

The earnings season of US banks will start on January 14th, when 4Q20 results are provided by First Republic. After that, within two weeks, all members of BKX index will provide quarterly results. US banks reported much better both revenue and EPS figures in 3Q20 despite fundamentals weren’t strong and revenue environment was quite challenging. Notwithstanding, positive EPS momentum, which began in 3Q20, remains, and we expect further upward revision of EPS estimates due to better visibility of earnings/revenues as a result of vaccination start, long-awaited announcement of new fiscal stimulus and a resumption of buybacks as early as in 1Q21. Unsurprisingly, EPS estimates were revised up substantially since the end of 3Q20. Thus, according to Bloomberg consensus, median growth of 4Q20 EPS of BKX index members was +24.5% qtd but still -17.2% ytd (as of December 24). Full-year estimates for both current and next year were also revised up on qtd basis. Median growth of EPS 2020/2021 of BKX index members was +12.0%/+7.8% qtd, respectively, but it was still -35.2%/-28.8% ytd. In turn, 4Q20 revenue estimates increased only by 0.4% qtd, still remaining negative ytd, -3.8%.

Despite market optimism on positive vaccine news, a majority of loan yields continued to go down in 4Q20 and NIM/NII pressure is still the key headwind for banks in the near future with negative impact on both top-line and bottom-line. From the other hand, quarterly average treasury yields and spreads moved slightly up on qoq basis and we think that NIM isn’t very far from trough, even despite the beginning of the rate hike cycle is still very far from us. Thus, median growth of 4Q20 NII estimates of BKX index members is -1.4% qtd, or -4.4% ytd. In turn, 4Q20 NIM projections declined by 8.7 bps qtd/-39 bps ytd while 2021/2022 NIM projections declined by 0.3/6.7 bps qtd respectively, being -27/-41 bps ytd.

In turn, December stress test results were a positive surprise for the market, especially taking into account relatively conservative decisions of EU/UK regulators regarding dividends which were announced a few days before the announcement in the USA. Capital distribution is still restricted by average net income over four recent quarters but it was a sign that capital ratios of US banks are high enough and that the worst is behind us. Unsurprisingly, it was perceived quite positive by the market as buybacks were one of the key EPS drivers during the last cycle. The key question is when the profit restriction is lifted. From the one hand, capital is strong and the restriction looks slightly excessive given current economic projections. On the other hand, the Fed remains flexible if the situation deteriorates because of adverse development of the pandemic. So, we expect that dividends of US banks will increase materially in the coming months. Median dividend yield for both FY20 and FY21 estimates of BKX index members is currently 3.1%.

Due to a number of positive news in recent months, banking quotes increased meaningfully in 3Q20, even despite fundamentals still remain challenging. Positive vaccine news, fiscal stimulus adoption and buybacks resumption improved visibility of future earnings markedly but risks are still tilted to the downside given the second wave of the pandemic, a deceleration of loan growth and ongoing NIM headwinds. After the recent rally, we don’t see any catalysts for US banking shares in the near future except for faster economic recovery and remaining momentum. Moreover, banks are no more trading with so high discount to historical averages as it was a few months ago, but they are still undervalued substantially vs S&P 500. The latter could remain an argument for growth in the near future, especially taking into account further growth of EPS estimates. Thus, banks are trading with -0.7 std / -0.6 std on P/E CY and -0.9 std / -0.6 std on P/E NY (on the basis of samples from 2000 and 2010 years to current moment) relative to historical averages (as of December 24, it was also used 21E/22E for CY/NY respectively). As for relative to S&P 500, banks are currently trading at -1.7 std and -1.8 std from the sample mean (2010-current moment) for P/E CY and P/E NY, respectively. On P/B, banks are trading with -0.7 std (vs -0.8 std for trailing ROE) from the sample mean (2010-current moment) vs SPX with +2.6 std (vs -2.2 std for trailing ROE). We still remain on the sidelines at current levels as risk/reward ratio isn’t already as attractive as it was in September/October. But we recommend to buy any sell-offs in banking shares as fundamentals are beginning to improve.

EU banks slightly increased in December after a skyrocketing growth in the previous month, when SX7P index showed the second best absolute monthly performance in the index history. Moreover, it underperformed the broad market again after two consecutive months of outperformance. So, both relative and absolute dynamics of EU banks remain weak ytd. On an absolute basis, SX7P index increased by 1.6% MTD in December, or +0.2 std from the mean, and it is the top 47% of absolute monthly performance of SX7P index. Relative monthly performance was -0.1% MTD, or +0.1 std, and it is the median relative monthly performance for SX7P index since inception. Despite an overwhelming growth in October and November, SX7P index is still underperformed the broad market by 19.3% ytd and it is -23.2% ytd on absolute basis. So, it is the third year in a row of relative underperformance for SX7P index.

Key outperformers in December were UK banks which were driven by Brexit optimism. On the other hand, Scandinavian banks were among key underperformers because of AML investigation news. UCG decreased by 11% MTD on news about CEO Mustier quit.

Current macro environment remains challenging for EU banks because of the second wave of the pandemic and new restrictions which will inevitably lead to GDP decline in 4Q20 and 1Q20. Despite better 3Q20 earnings season and better visibility of LT earnings due to positive vaccine news, risks are still tilted to the downside while fundamentals remain weak. Moreover, the ECB lifted dividend ban only partially and it was clear message that EU banking sector hasn’t been out of the woods yet. It was allowed to pay in dividends or buybacks no more than 15% of total profit for 2019-2020 and/or no more than 20 bps of CET1 ratio, whichever is lower. Because of recent rally, EU banks is no more trading with discount to historical averages while a discount to US peers is much lower than it was in the past. EU banks are cheap vs the broad EU index but they are cheap for a reason. Thus, premium to historical averages is +18% (+1.0 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 9.8% at the moment vs average since 2010 of 20.3%, or +1.2 std, unreasonable, from our point of view, given higher risks associated with EU banks and much more challenging revenue environment. So, we continue prefer US banks to EU ones at the moment.

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