HomeResearch and NewsArbat Capital: Banking Sector Report - September 2019

Arbat Capital: Banking Sector Report - September 2019


US banks significantly outperformed the broad market in September after very weak dynamics in August. But it still underperforms S&P 500 index ytd. Thus, BKX index increased by 7.5% MoM in September vs +1.7% of SPX index. Absolute September performance on MoM basis was +1 std from the mean and it is in the top 12% of the absolute MoM performance of BKX index. Relative September performance was +5.6% MoM, it is +1.2 std from the mean and it is in the top 8% of relative MoM performance vs SPX index since 1992. Moreover, it was the best September absolute performance of BKX index in history. BKX index is currently +16.6% ytd, and it is still the strongest growth in absolute terms over the last 6 years. On relative basis, it is -1.8% ytd, the fourth year in a row of negative relative performance of the first 9 months of the year.

Dynamics within the sector was relatively uniform with positive performance of all members of BKX index except for AXP. The key drivers of the sector were rebound of interest rates and more positive than expected guidance during various financial conferences in September.

The earnings season of US banks will start on October 15th, when 3Q19 results are provided by JP Morgan, Citigroup and Wells Fargo. After that, within two weeks, all members of BKX index will provide the quarterly results. It was a messy quarter again with significant volatility of key benchmark yields and worsening economic outlook. According to Bloomberg consensus, median decline of 3Q19 EPS of BKX index members is -2.7% QTD or -4.7% YTD. It wasn’t surprising given rates dynamics ytd. Full-year estimates for the current and next years were also revised down YTD by -2.8% and -6.8%, respectively. But we expect that full-year EPS estimates will continue to go down in the near future given recent Fed cuts, substantial decline of key benchmark yields ytd, partly inverted yield curve and no acceleration of loan growth while fee income dynamics remains relatively poor despite growth of mortgage fees. The risk of recession also increased markedly, from our point of view, due to ongoing trade tensions and global slowdown implying that provision expense growth could accelerate while loan growth should decelerate. Moreover, 3Q19 numbers should be relatively weak with median growth of EPS of BKX index members of just 1.5% yoy but -1.4% qoq, the weakest growth on yoy basis over last 3 years. We expect that much attention will be directed to NII/NIM dynamics even despite rates rose from recent lows in September. Not only numbers are important, guidance either. Other operating figures remain pretty resilient but situation, from our point of view, could change quickly taking into account increased risk of recession.

Average 1M Libor decreased by 26.1 bps qoq in 3Q19 and average 3M Libor lost 30.7 bps qoq while average prime rate went down by 18.8 bps qoq. Given significant decline of key benchmark rates, two rate cuts in 3Q19 and lowered rate expectations, it is expected that NIM will decline sequentially again, for the second quarter in a row. According to Bloomberg consensus estimates, median decline of NIM of BKX index member in 3Q19 is 5 bps qoq and it is expected to decrease by 10 bps yoy, the second quarter in a row of yoy decline. In turn, median growth of NII is +0.5% qoq or +1.5% yoy. NII growth is driven by growth of earnings assets. Notwithstanding, estimates have already declined and we expect that projections will continue to go down till the start of the earnings season. Thus, median decline of 3Q19 NII estimates of BKX index members is 2.7% qtd or -3.1% ytd. NIM has already declined by 8.9 bps qtd and 14.2 bps ytd.

Overall, operating trends of US banks are gradually deteriorating with more challenging revenue environment but still high credit quality, good cost control and small but positive operating leverage. We still see almost no EPS drivers except for buyback while among the growth catalysts, in fact, only low valuations remained. Thus, banks continue to trade with significant discount to S&P 500 index, reflecting late cycle concerns. Thus, banks are trading with -1.8/-1.6 std on P/E CY and -1.2/-0.9 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 -2.2 std and -1.8 std from the sample mean (2010- current moment) for P/E CY and P/E NY, respectively.

Despite stocks are still trading at a significant discount, we maintain our cautious view on US banks given higher risks and still optimistic dynamics of banking shares in 2019. NIM prospects are very weak given ongoing decline of key benchmark rates and we expect that loan growth will offset it only partially as risk of recession continues to go up. In turn, there is no more a big room for credit costs and opex reduction. Capital return will remain high near term but it is too little to change the mood of investors given late cycle concerns. So, we believe that banks with weak deposit franchise as well as with high rate sensitivity will perform much worse than the others ones.

EU banks skyrocketed in September, finally outperforming the broad market after four consecutive months of underperformance. On absolute basis, SX7P index increased by 9% MoM in September or +1.3 std from the mean and this result is in the top 6% of absolute monthly performance of SX7P since the index inception. Also, relative monthly performance was +5.1% MoM or +1.5 std and it is in the top 6% of relative monthly performance. Despite significant growth in September, SX7P index is still -0.4% ytd even on absolute basis while on relative basis it is -14.4% ytd with negative MoM relative performance in 6 out of 9 month of this year.

As well as in US, the key driver of the sector was significant growth of benchmark rates. So, all asset sensitive banks were among winners in September. SydBank that decreased by 19% in August, was also driven by news of M&A talks with Spar Nord Bank. Among outsiders were German banks because of weak macro figures and ABN Amro as a result of announcement of money laundering probe.

Rebound in rates was a cause of a recent bounce in EU banking shares but fundamentals continue to worsen. EU macro data published in September was weak again despite more accommodative monetary policy. Thus, ECB lowered the deposit rate by 10 bps to -0.5% at the September meeting while composite PMI of EU was just 50.1 pts and German composite PMI fell below 50 pts, pointing to further deceleration of the economy. Overall, ECB September meeting was slightly more hawkish than expected and the probability of another rate cut till the end of the year decreased to 40% as the end of September vs 80% as the end of August. But even despite announcement of tiering and relaxation of TLTRO terms, the entire German yield curve remains below zero line while 3Mo Euribor rates are implied to be negative for more than 5 years since now, assuming that challenging revenue environment for EU banks will last for a long time. ECB’s mantra regarding the recession remains unchanged but “the risks surrounding the euro area growth outlook remain tilted to the downside, on account of the prolonged presence of uncertainties, related to geopolitical factors, the rising threat of protectionism and vulnerabilities in emerging markets”. Unsurprisingly, 2Q19 operating results were weak again with yoy decline of net income for the second consecutive quarter. So, EPS estimates continue to go down. Thus, median decline of FY2019 EPS estimates of SX7P index is -8.5% ytd while FY2020 is -12.3% ytd. Given lack of opex and NPL reduction opportunities, especially taking into account rising recession risks, EU bank continue to trade with significant discount to historical averages (-22% / -1.4 Std from mean P/E CY of SX7P index members, sample from 2010 to the present) but discount to US peers (on median P/E CY of BKX index vs SX7P index) is 20% at the moment vs average of 16% since 2010, still minor, from our point of view, given higher risks.

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