EXECUTIVE SUMMARY

US banks increased significantly in November after substantial outperformance in October. So, US banks grew much faster than the broad market index for the second month in a row after five consecutive months of underperformance. It was the second best month on absolute basis in BKX index history. Thus, BKX index rallied by 17.4% MoM in November vs +10.8% MoM of SPX index. Absolute performance on MoM basis was +2.4 std from the mean. Relative November performance was +6.0% MoM. It is +1.3 std from the mean and it is in the top 8% of relative MoM performance vs SPX index since 1992. Despite significant outperformance in two recent months, it is still the worst year on a relative performance basis for BKX index since inception and the worst one on an absolute basis over the last 9 years.

All US banks increased in November but the dynamics of BKX index members weren’t uniform, even despite it was driven by macro factors such as election outcome and positive vaccine news. So, such YTD laggards like WFC and C increased by 27-33% MoM in November while some regionals increased only by 10% MoM or less.

Despite the second wave of the pandemic, economic recovery remains intact while positive vaccine news has improved visibility of future earnings, especially taking into account stronger 3Q20 earnings season and growth of the long end in recent months. So, both economic projections and revenue/EPS estimates continue improving. But we don’t see potential for significant growth of estimates from current levels, taking into account weak for longer NII/NIM prospects. The long end growth is positive for interest revenues, but majority of earning assets are priced based on the short end of the curve while loan growth still remains anemic even despite better prospects of the economy. One of the key remaining catalysts for banking stocks is buybacks ban lifting, but it seems that it is already largely priced in, given significant outperformance of banks in two recent months. Uncertainty is still high, from our point of view, while recent rally implies that we have already been out of the woods. Moreover, banks are no more trading with discount to historical averages, but it is still undervalued vs S&P 500. However, valuations will inevitably improve in the near term due to EPS estimates growth. Notwithstanding, US banks don’t look cheap for us anymore. Thus, banks are trading with +1.5/+1.4 std on P/E CY and +0.2/+0.4 on P/E NY (on the basis of samples from 2000 and 2010 years to current moment) relative to historical averages (as of November 27). As for relative to S&P 500, banks are currently trading at -1.5 std and -1.7 std from the sample mean (2010-current moment) for P/E CY and P/E NY, respectively. On P/B, banks are trading with -1.0 std from the sample mean (2010-current moment) vs SPX with +2.2 std. Banks are cheap vs SPX but cheap for a reason, from our point of view. So, we are again on the sidelines as risk/reward ratio isn’t already as attractive as it was one or two months ago.

EU banks skyrocketed in November after very weak dynamics in almost every month of 2020. It outperformed the broad market again, for the second consecutive month with an overall relative performance of more than 20%. Notwithstanding, both relative and absolute dynamics of EU banks remain weak ytd. On an absolute basis, SX7P index increased by 30.2% MoM in November or +4.4 std from the mean and it is the second best absolute monthly performance of SX7P index since inception. Relative monthly performance was +14.4% MoM or +3.9 std and it is also the second best relative monthly performance in index history. Despite overwhelming growth in two last months, SX7P index is still underperformed the broad market by 19.3% ytd and it is -24.4% ytd on absolute basis. Moreover, it might be said almost with confidence that it will be the third year in a row of relative underperformance for SX7P index.

All members of SX7P index increased in November driven mainly by positive vaccine news. But it wasn’t uniform dynamics. Thus, BBVA and Santander skyrocketed by 48-60% MoM while Swedbank and Nordea added just around 10% MoM.

European banks reported significantly better results in 3Q20 as it did in 2Q20 after weaker figures in 1Q20. Both revenue and net income figures demonstrated positive surprises. Thus, 30 out of 40 banks from SX7P index for which estimates were available reported better revenue figures vs 17 out of 24 in 2Q20. Net income was also better than expected with 32 out 36 banks with positive surprises. EPS was higher for 25 out of 35 banks in 3Q20 vs 26 out of 32 banks in 2Q20. The key driver of better results was significant decline of estimates and lower provisions due to more optimistic economic outlook. In turn, NII/NIM figures were weak again. Notwithstanding, earnings momentum began to improve after significant worsening in 1H20. Thus, median decline of operating profit of SX7P index members increased from -44% yoy in 2Q20 to -20% yoy in 3Q20. Median decline of revenue was -2.5% yoy in 3Q20 after it decreased by 3.4% yoy in 2Q20. In turn, median revenue surprise was +3.0%, the strongest beat over last 15 quarters. Revenue decline was driven by NII which decreased by 5.3% yoy in 3Q20 after drop by 2.8% yoy in 2Q20. Despite better earnings season and overall optimism due to positive vaccine news and diminished risks after US elections, market perception of the results was mixed. Thus, median 1-day performance of SX7P index members around the earnings date was -0.9% during 3Q20 earnings season vs 10yr average of +0.16%.

Median decline of EU banks net income (SX7P index members) was 21.4% yoy in 3Q20 after drop by 33% yoy in 2Q20 and by 40% yoy in 1Q20. And it seems that banks will reach pre-pandemic level not earlier than in 2H22 given negative rate environment in the foreseeable future. At least, current estimates imply that FY21 net income estimates are 38% lower than FY19 net income actuals (median decline of SX7P index). Despite sizeable growth of NI sequentially, median ROE of EU banks continue declining, -25 bps qoq or -314 bps yoy to 4.9%, the lowest figure over 23 last quarters. Due to positive EPS and revenue surprises as well as good cost control and improved expectations, estimates have increased meaningfully in recent weeks. Thus, median growth of FY20 NI was 7.6% qtd but -53% ytd, implying decline of 51% yoy. As of FY21 NI estimates, median growth was +6.7% qtd but -41% ytd, implying growth of 15% yoy. From the other hand, revenue estimates were relatively flat with growth by 0.4% qtd for FY20 revenue but decline by 0.1% qtd for the next year.

Despite better earnings season and more optimistic view on economic recovery in coming years due to positive vaccine news, expectations of future both fiscal and monetary stimuli as well as possible lifting of the dividends ban in December, we don’t expect that outperformance of EU banks will continue. From the one hand, recent developments improved economic outlook and visibility of banking earnings. From the other hand, banking fundamentals will remain relatively weak in coming years because of ongoing negative rate environment and sluggish loan growth. At least, we expect that EPS estimates will return to 2019 levels not earlier than in 2H22 while revenue return will take even longer. From our point of view, the worst is behind us but it is bumpy road ahead with risks still tilted to downside. Also, EU banks is no more trading with discount to historical averages while discount to US peers is much lower than it was usually. It is cheap vs the broad EU index but it is cheap for a reason. Thus, premium to historical averages is +19% (+1.1 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 9.9% 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 new lockdowns in the region. So, we continue prefer US banks to EU ones at the moment.

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12 August 2020, Arbat Capital

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