HomeResearch and NewsArbat Capital: Banking Sector Report - November 2019

Arbat Capital: Banking Sector Report - November 2019

EXECUTIVE SUMMARY

US banks markedly outperformed the broad market in November, the third consecutive month of outperformance after very weak dynamics in August. Thus, BKX index increased by 5.7% MoM in November vs +3.4% of SPX index. Absolute November performance on MoM basis was +0.8 std from the mean and it is in the top 20% of the absolute MoM performance of BKX index. Relative November performance was +2.3% MoM, it is +0.5 std from the mean and it is in the top 28% of relative MoM performance vs SPX index since 1992. BKX index is currently +27.9% ytd, and it is the strongest growth of the first 11 months of the year in absolute terms over the last 6 years. On relative basis, it is +2% ytd after two years in a row of underperformance. Dynamics within the sector was relatively uniform with positive performance of all members of BKX index. The key drivers of the sector were rebound of interest rates and stabilization of macro data. So, the key outperformers were asset sensitive regional banks and trust banks, such as STT, CMA and SNV. From the other hand, liability sensitive NYCB was among laggards. October FOMC minutes brought us little news. The FOMC feels comfortable about the current stance of US economy but it was noted again that risks are still skewed to the downside. So, we will hardly see another rate cut until economic situation worsen materially while rate cut expectations has declined significantly in recent months. Macro data were slightly better than expected in November with positive surprises on payrolls and retail sales while 3Q19 annualized GDP growth was revised up from 1.9% qoq to 2.1% qoq. Due to macro stabilization rates continue to go up but we don’t expect that it will be long lasting tendency given the late cycle and still relatively high risks relating to trade war and global economy slowdown. It should be noted that 2020 is election year which will also add uncertainty to the markets taking into account high polarization of US society. Despite US economy is still strong, leading indicators are starting to point to further slowdown while manufacturing sector has almost started to contract. The probability of recession in 2020 is still relatively high and we don’t exclude that FF rate will be cut to zero in that case. So far, banks have successfully coped with both rate cuts and yield curve flattening due to strong loan and asset growth. But in case of further US economy slowdown, it will be also accompanied by loan growth deceleration and asset quality deterioration. Both total loan growth and credit quality were relatively flat on yoy basis in recent years. But C&I loans growth decelerated from 7.6% yoy 1 year ago to just 3.7% yoy in November 2019. The same time NCO ratio of the segment increased by 18 bps yoy to 0.43% in 3Q19, the highest figure over 3 years, reflecting contraction of manufacturing sector. And it potentially could be a big problem given high leverage of corporate sector. Given still challenging revenue environment, high uncertainty in the economy and significant growth of banking stocks in the current year, the US banking sector is no more attractive from risk/reward point of view. Discount of US banks to S&P 500 index and historical averages has declined significantly. Thus, US banks are trading with -1.1/-1.0 std on P/E CY and -0.5/-0.3 std on P/E NY (on the basis of samples from 2000 and 2010 yrs to current moment) relative to historical averages. As for relative to S&P 500, banks are currently trading at -2.0 and -1.6 std from the sample mean (2010-current moment) for P/E CY and P/E NY, respectively. EU banks slightly underperformed the broad market in November after two consecutive months of outperformance. On absolute basis, SX7P index increased by 2.5% MoM in November or +0.3 std from the mean and this result is in the top 38% of absolute monthly performance of SX7P since the index inception. Relative monthly performance was -0.2% MoM or +0.02 std and it is in the bottom 49% of relative monthly performance of SX7P index. Notwithstanding, despite significant growth in recent months, SX7P index is still just +3.8% ytd even on absolute basis while on relative basis it is -13.9% ytd with negative MoM relative performance in 6 out of 11 months of this year. Contrary to US banks, dynamics of EU peers was multidirectional because of residual effects of the earnings season. Thus, VMUK LN, UCG IM and GLE FP were among the best performers due to better than expected quarterly results. From the other hand, KN FP declined markedly because of relatively weak figures. There were also SWEDA SS and SEBA SS among underperformers as a result of ongoing money laundering scandal. European banks reported almost in-line figures in 3Q19 after marked decline of estimates ytd due to better revenue dynamics even despite significant decline of key benchmark yields. Thus, 15 out of 31 banks from SX7P index for which estimates were available reported positive surprises on EPS. Earnings momentum also improved in 3Q19 after two consecutive quarters of negative yoy dynamics of operating profit. From the other hand, operating figures still remain relatively weak while management outlook was more cautious. So, net income estimates continue to go down as risks remain high. At least, global economy continues to slow down, yields and rate expectations still markedly lower ytd despite significant growth in September-November while Brexit is on the table yet. So, market perception of the results was negative despite ongoing rebound of the broad market from September lows. Thus, median 1-day performance of SX7P index members around the earnings date was -0.7% during 3Q19 earnings season vs -0.22% in 2Q19. In turn, SX7P index decreased by 0.7% since the close of October 21, a day before the first member of SX7P index reported its 3Q19 results, and till the end of November while STOXX 600 index increased by 3.4% over the same period. Median growth of net income of EU banks was 1.6% yoy in 3Q19 following three consecutive quarters of negative yoy growth. The key driver of better NI dynamics were higher revenues, both NII and fees, which surpassed the negative impact of growing opex and provisions. So, median ROE of EU banks declined by 72 bps yoy or -42 bps qoq to 8.2%. The key disappointment of the earnings season is not the current figures themselves, but the weak outlook and ongoing growth of provisions because of weaker economy. Consequently, expectations continue to be revised down. Thus, median decline of FY2019 revenue estimates is 2.8% ytd, -0.2% qtd, implying decline of 7.6% yoy. As of FY2020 revenue estimates, median decline is 4.6% ytd or -0.3% qtd. Median EPS 2019 decline is 9.5% ytd or -1.2% qtd while median EPS 2020 decline is 14.1%ytd or -1.4% qtd. Despite to significant growth in recent months, European banks continue to trade at marked discount on both historical averages and US peers. However, from our point of view, the European banks are cheap but they are cheap for a reason. Moreover, discount declined markedly in September-November. Thus, EU banks trading at 8.9x P/E CY vs median for the sample from 2010 to the present of 10.9x, -1.1 std. For P/E NY it is -0.5 std for the same sample. But vs US peers current discount (on median P/E CY of BKX index vs SX7P index) is 23% vs average of 16% since 2010, just -0.8 std while operating environment of US peers are much less risky, from our point of view. Upside, implied by Bloomberg consensus price targets, is around 10% at the moment, lower than the mean of the sample since 2010 or -0.4 std. So, full realization of the upside is highly questionable, taking into account weak revenue prospects, high political uncertainty, deceleration of GDP growth and significant growth of banking quotes in recent months. The key problem for EU banks is lower for longer interest rate environment while structural problems of EU banking sector hasn’t been resolved yet. We don’t see catalysts for EU banks near term.

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