EXECUTIVE SUMMARY

US banks increased significantly in October after substantial decline in September. So, US banks outperformed the broad market for the first time over the last six months. It was the best month for banks vs SPX index since November 2016. Thus, BKX index increased by 5.3% MoM in October vs -2.8% MoM of SPX index. Absolute performance on MoM basis was +0.7 std from the mean and it is in the top 22% of absolute MoM performance of BKX index. Relative October performance was +8.2% MoM. It is +1.8 std from the mean and it is in the top 4% of relative MoM performance vs SPX index since 1992. Notwithstanding, it is still the worst ten months of the year on a relative basis since the index inception while it is also the worst calendar year at the moment on an absolute basis since 2008.

Majority of US banks increased in October but dynamics of BKX index members weren’t uniform as a result of the earnings season. So, WFC and AXP, whose reports were relatively weak, decreased meaningfully. In turn, regional banks with better results than expected skyrocketed by 15-20% MoM. 

US banks reported encouraging 3Q20 results with much better both revenue and EPS figures. But we don’t expect a significant revision of forecasts up further given very weak NIM figures and reacceleration of the pandemic. Moreover, the key drivers of positive revenue surprises, capital markets and mortgage fees, don’t look sustainable at current levels while banks are still expecting significant deterioration of asset quality in 2021. Notwithstanding, underlying trends remain solid and such figures could be a catalyst for those investors who preferred to stay away from banking stocks given the depth of economic decline in 1H20, especially taking into account significant underperformance ytd and very deep discount to S&P500 index on P/E forward. 21 out of 24 of our group of banks demonstrated positive EPS surprises, the highest figure over last 9 quarters vs median number of positive quarterly EPS surprises over the last 55 quarters of 17. Median EPS surprise for our group of banks was +11.1% vs median quarterly figure over the last 13 years of +3.6%. Revenue surprise was positive again, the 20^th quarter over the last 23 quarters, +1.8% vs median quarterly figure over the last 13 years of +0.8%. 20 companies of our group of banks, or 87%, demonstrated positive surprise on revenue, significantly higher than median quarterly figure since Q1 2007. Notwithstanding, market perception of the results was neutral with significant decline in the first days of the earning season, when results were reported by the largest US banks. Thus, median percent change in price around the earnings date of our group of banks was -0.14% vs +1.1% in 2Q20 and -0.8% in 1Q20 and median figure since 1Q07 of -0.3%. However, BKX index decreased by 4.4% since the start of the earnings season till the end of October (closed price on October 30) while S&P 500 index lost 7.5%. In turn, consensus estimates improved significantly during the earnings season. Thus, 4Q20 EPS estimates were revised up by 13.8% since October 12 (median of BKX index members) but still -19.6% ytd, FY20 EPS estimates were +8% since the start of the earnings season but -35.7% ytd while median change of FY21 EPS estimates was +3.3% and -31.1%, respectively.

Overall, underlying trends of US banks were better sequentially but the current situation is still far from being normal, especially taking into account NIM dynamics. Notwithstanding, ROE/ROA figures increased significantly in 3Q20 from the decade lows, shown in 2Q20. Thus, ROE skyrocketed by 414 bps qoq to 9.8% in 3Q20, -170 bps from average level of 2018/19 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 2H20/21 years. Notwithstanding, banks are properly reserved, from our point of view, and we rather expect reserve release than its build in 2021, especially if economy continues the recovery at an expected pace. 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 -0.2/-0.2 std on P/E CY and -1.3/-1.0 on P/E NY (on the basis of samples from 2000 and 2010 yrs to current moment) relative to historical averages (as of October 30). As for relative to S&P 500, banks are currently trading at -2.0 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 -1.6 std from the sample mean (2010-current moment) vs SPX with +1.7 std. Uncertainty still remains high and it will remain high in the near term as a result of upcoming elections, problems with vaccines and the second wave of the pandemic, but we are becoming more and more optimistic about the prospects of US banks given their significant underperformance and meaningful discount to S&P 500 index. We don’t think that we are out of the woods at the moment, but we believe that the worst is behind us. So, we assess the current risk/reward ratio as attractive and recommend buying US banking stocks.

EU banks slightly increased in October after significant drop in September but they outperformed the broad market substantially, demonstrating the best relative performance on MoM basis over the last four years. Notwithstanding, dynamics of EU banks remain very weak with 6 out of 10 months of 2020 in the red zone. On an absolute basis, SX7P index went up by 0.7% MoM in September, or +0.1 std from the mean, and this result is in the bottom 48% of absolute monthly performance of SX7P since index inception. Relative monthly performance was +6.2% MoM, or +1.7 std, and it is in the top 4% of relative performance in index history. 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 the broad market considerably. On ytd basis, SX7P underperformed by 29.4% as of the end of October.

The key drivers of EU banks were the start of earnings season and the news about new lockdowns because of the second wave of the pandemic. So, dynamics of EU banks were multidirectional with a very wide range of MoM performance among SX7P index members.

European macro data published in October was slightly better than expected with markedly better 3Q20 GDP growth figures across majority of EU countries. But the ECB also noted that economic recovery was losing momentum more rapidly than expected. And risks have increased significantly in recent months given skyrocketing growth of new COVID-19 cases. The ECB gave us a clear signal that new monetary stimulus will be announced in December but we don’t think that it could be a game changer for EU banks, even if we see new fiscal stimulus in the near future. Despite the start of 3Q20 earnings season was better than expected, banking fundamentals still remain weak. So, estimates are much lower on ytd basis but relatively flat MoM. Thus, median decline of NII FY20 estimates of EU banks was 0.3% MoM, or -5.3% ytd, while FY21 estimates declined by 6.4% ytd, but flat MoM. FY20 revenue estimates remained flat MoM, but -5.1% ytd, while FY21 revenues declined by 0.1% MoM, or -6.9% ytd. In turn, growth of FY20 EPS was 3.3% MoM, but -53.2% ytd, while FY21 EPS increased by 0.1% MoM, but -42.1% ytd. Recent ECB’s decision to extend the prohibition on dividends and buybacks isn’t a positive catalyst for EU bank shares either, especially taking into account that EU banks is no more trading with discount to their historical averages while the discount to US peers is much lower than usual. Thus, discount to US peers (on median P/E NY of BKX index vs SX7P index) is just 15% at the moment vs average since 2010 of 20.4%, unreasonable, from our point of view, given higher risks associated with EU banks and new lockdowns in the region. So, we continue to prefer US banks to EU ones.

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11 September 2020, Arbat Capital

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