EXECUTIVE SUMMARY

US banks were flat in July as it was in two previous months following very volatile first four months of the year. But banks underperformed the broad market again, the sixth month of weaker dynamics over last 7. Thus, BKX index increased by 0.3% MoM as of July 30 vs +1.8% MoM of SPX index. Absolute performance on MoM basis was -0.04 std from the mean and it is in the bottom 46% of absolute MoM performance of BKX index. Relative July performance was -4.2% MoM. It is -0.9 std from the mean and it is in the bottom 14% of relative MoM performance vs SPX index since 1992. It was by a wide margin the worst first seven months of the year on relative basis in BKX index history and it was the worst start of the year on absolute basis either.

The key driver of individual bank price dynamics was the earnings season which wasn’t strong. Banks with better quarterly results were among outperformers. Thus, NYCB increased by more than 6% MoM, being one of the few banks with positive dynamics of NIM. From the other hand, banks with weaker results lost 6-9% MoM.

US banks reported mixed results again with much better EPS and revenue figures despite higher provisions and weaker NII/NIM numbers. From the other hand, the key driver of better results was strong capital markets and IB fees which don’t look sustainable at these levels, from our point of view. Other core fees were weak while banks also expect that market-related revenues will be lower in 2H20. Underlying trends weren’t strong and banking fundamentals will remain under pressure in the coming quarters even despite better macro data in June and July. Thus, 17 out of 24 of our group of banks demonstrated positive EPS surprises, in line with median number of positive quarterly EPS surprises over the last 54 quarters after the lowest figure over more than 11 years of just 6 positive EPS surprises in 1Q20. In turn, median EPS surprise for our group of banks was +19% vs median quarterly figure over the last 13 years of 3.5%. Revenue surprise was positive again, the 19^th quarter over the last 22 quarters, +2.2% vs median quarterly figure over the last 13 years of 0.8%. 18 companies of our group of banks or 75% demonstrated positive surprise on revenue, markedly higher than median quarterly figure since Q107. Unsurprisingly, market perception of the results was positive after two consecutive quarters of negative perception. Thus, median percent change in price around the earnings date of our group of banks was +1.1% vs -0.8% in 1Q20 and -1.8% in 4Q20 and median figure since 1Q07 of -0.3%. However, BKX index increased only by 1% since the start of the earnings season till the end of July (closed price on July 30) while S&P 500 index added 2.9%. Notwithstanding, consensus estimates moved in different directions during the earnings season with growth of current year estimates and decline of the next year estimates. Thus, 3Q20 EPS estimates were revised up by 7.5% since July 13 (median of BKX index members) but still -35% ytd, FY20 EPS estimates were +5.8% since the start of the earnings season but -47.4% ytd while median change of FY21 EPS estimates was -3.8% and -33.3%, respectively.

Overall, underlying trends of US banks deteriorated in 2Q20 with substantial decline of ROE even despite strong growth of fee income due to trading momentum. Thus, ROE decreased by 60 bps qoq to just 5.7% in 2Q20, the lowest figure over more than 10 years. Key credit metrics of US banks still remained pretty resilient due to forbearance actions of banks and unprecedented fiscal and monetary stimuli despite significant decline of GDP and skyrocketed growth of unemployment in 1H20. But asset quality will inevitably deteriorate in 2H20 and the following 2021 year. At least, a number of bankruptcies and rating downgrades have already increased considerably. Given significant decline of NIM, start of corporate loans repayments and relatively week fee income (except for trading), we expect that revenue prospects will remain bleak in the nearest quarters even if economic recovery remains solid.

So, banks continue underperform the broad market. Due to significant decline of EPS estimates, banks is no more trading with significant discount to CY estimates but they are still undervalued to NY estimates and vs S&P 500. Thus, banks are trading with +0.9/+0.9 std on P/E CY and -1.0/-0.8 on P/E NY (on the basis of samples from 2000 and 2010 years to current moment) relative to historical averages (as of July 30). As for relative to S&P 500, banks are currently trading at -1.9 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 with -1.9 std from the sample mean (2010-current moment) vs SPX with +2 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 and still high level of uncertainty about the speed of US economic recovery. 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.

EU banks markedly decreased in July after significant growth in June. But dynamics of EU banks remains very weak. SX7P index ended 5 out of 7 months of 2020 in the red zone. On absolute basis, SX7P index decreased by 4.5% MoM in July or -0.7 std from the mean and this result is in the bottom 20% of absolute monthly performance of SX7P since index inception. Also, relative monthly performance was -4.2% MoM or -1.1 std and it is in the bottom 11% 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 27% as the end of July.

Dynamics of European banks was bidirectional in July because of the earnings season beginning. Thus, key outperformers were banks with better quarterly figures which added more than 15% MoM. Banks with weaker figures lost more than 12% MoM with very weak dynamics of all UK banks.

European macro data published in July was markedly better than expected with positive surprises on majority macro figures. But GDP decline in 2Q20 was the most on record while high frequency data has signaled recently that recovery is starting to slow down. Despite faster recovery than expected, expectations were relatively unchanged in June and July. Given significant PEPP increase in June, monetary policy remained unchanged at July meeting. And it was noted during press conference that entire envelope of the PEPP will be used, unless there were significant upside surprises, which isn’t the baseline scenario. Moreover, it seems that PEPP size could be increased once more if situation worsens. It is quite possible scenario in case of the second wave which probability isn’t low given the growth of COVID-19 cases in a number of countries after restrictions were lifted. Start of 2Q20 earnings season was slightly better than feared but fundamentals still remain relatively weak. So, estimates are much lower on ytd basis but flat MoM. Thus, median decline of NII FY20 estimates of EU banks was flat MoM but -5% ytd while FY21 estimates declined by 7.3 ytd. Median NIM FY20 estimate increased by 0.7 bps MoM and by 24.5 bps ytd to 1.77% while NIM FY21 was flat qoq but +16.9 bps qoq to 1.68% as the end of July. Recent ECB’s decision to extend prohibition on dividends and buybacks isn’t a positive catalyst for EU bank shares, especially taking into account that EU banks is no more trading with discount to historical averages while discount to US peers is much lower than usually. Thus, discount to US peers (on median P/E NY of BKX index vs SX7P index) is just 10.2% at the moment vs average since 2010 of 21.3%, unreasonable, from our point of view, given higher risks associated with EUbanks.

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08 May 2020, Arbat Capital

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