EXECUTIVE SUMMARY

US banks decreased in September after moderate growth in August. So, the banking industry index broke down its growth channel and underperformed the broad market again. It was the 5^th month in a row of relative underperformance with overall absolute decline of 36% ytd vs S&P 500 index growth of 4% ytd. BKX index decreased by 4.7% MoM in September vs -3.9% MoM of SPX index. Absolute performance on MoM basis was -0.8 std from the mean and it is in the bottom 19% of absolute MoM performance of BKX index. Relative September performance was -0.8% MoM. It is -0.15 std from the mean and it is in the bottom 44% of relative MoM performance vs SPX index since 1992. It was by a wide margin the worst first three quarters of the year on both absolute and especially relative basis in BKX index history.

Key outperformers in September 2020 were consumer finance companies again as quality characteristics of consumer loans remains resilient while employment dynamics is encouraging. The worst performer was Citigroup which tumbled by 15.7% MoM as a result of weaker mid-quarter guidance and news that regulators could take actions against Citi.

The earnings season of US banks will start on October, 13, when 3Q20 results are expected to be provided by JP Morgan and Citigroup. After that, within two weeks, all members of BKX index will release their quarterly results. US banks reported mixed figures in 2Q20 with much better EPS and revenue figures despite higher provisions and lower NII/NIM. We expect that positive EPS momentum is returning due to better than expected asset quality, still solid trading/IB/mortgage fees and strong deposit inflows. From the other hand, NIM and loan dynamics remain weak. Notwithstanding, EPS estimates were revised up substantially since the end of 2Q20. Thus, according to Bloomberg consensus, median growth of 3Q20 EPS of BKX index members was 24.7% qtd but still -30.4% ytd (as of September, 28). Full-year estimates for the current year was revised up by 10.5% qtd but still -46.2% ytd while next year EPS declined by 4.6% qtd / -34.7% ytd. In turn, 3Q20 revenue estimates increased by 0.4% qtd, still remaining negative ytd.

Revenue estimates increased by 0.4% qtd, driven by fees while NII remains a drag. Thus, non-interest income estimates increased by 3.7% qtd while NII declined by 2.4% qtd. Notwithstanding, according to Bloomberg consensus, non-interest income of BKX index members will decrease by 4.1% qoq and by 5.0% yoy in 3Q20, even despite capital markets and mortgage remains strong while other fees will inevitably recover after significant drop in 2Q20. In turn, it is implied that NII will be flat qoq but -1.6% yoy, even despite deceleration of loan growth in 3Q20 and NIM decline. Majority of quarterly average benchmark rates dropped meaningfully in 3Q20 while banks invest strong deposit inflows in highly liquid assets. So, 3Q20 NIM estimated declined by 13 bps qtd while 2021/2022 NIM projections declined by 3.0/3.4 bps qtd respectively, being -26/-33 bps ytd. We believe that NIM is already not far from the trough of the cycle but we don’t expect that it will be markedly higher relative to current levels in foreseeable future, especially taking into account results of the recent Fed meetings and inflation forecasts.

Credit quality of US banks remains strong given the depth of recession in 1H20. Uncertainty is still high but early stage indicators have improved recently. Moreover, banks were also optimistic about credit during recent financial conferences and they don’t expect any significant reserve build in 3Q20. Unsurprisingly, provision estimates decreased by 8.6% qtd and it is expected that median decline will be 59% qoq. Better asset quality and lower provisions could be a catalyst for outperformance of banking stocks in the near term, from our point of view.

Capital ratios of US banks remain strong and they will continue their growth in 2H20 as it is unlikely that regulatory restrictions on buybacks and dividends will be lifted in coming months even despite it is quite probable that all banks will pass 4Q20 stress test, the scenarios of which were released by the Fed recently.

Due to significant decline of EPS estimates ytd, banks in general are no more trading with discount to CY estimates, but they are still undervalued significantly to NY estimates and vs S&P 500. Thus, banks are trading at -1.6/-1.2 std on P/E NY (on the basis of samples from 2000 and 2010 years to current moment) relative to historical averages (as of September, 25). As for relative to S&P 500, banks are currently trading at -2.2 std and -2.4 std from the sample mean (2010-current moment) for P/E CY and P/E NY, respectively. On P/B, banks are trading at -1.9 std from the sample mean (2010-current moment) vs SPX. We still see some risks for fundamentals of US banks given unprecedented decline of US economy in 1H20, still high level of uncertainty about the speed of US economic recovery, mixed 2Q20 results and rising risk related to the elections. Notwithstanding, we are becoming more and more optimistic given recent improvement of earnings momentum and high to ignore discount to S&P 500 index. So, we recommend buying US banks before 3Q20 earnings season as we expect better results and we believe that risk/reward looks attractive at the moment.

EU banks tumbled significantly in September 2020 after substantial growth in August. And their index dynamics remains very weak. SX7P index ended 6 out of 9 months of 2020 in the red zone. On absolute basis, SX7P index went down by 10.7% MoM in September or -1.6 std from the mean and this result is in the bottom 6% of absolute monthly performance of SX7P since index inception. Relative monthly performance was -9.4% MoM or -2.5 std and it is the 5^th worst month 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 broad market considerably. On ytd basis, SX7P underperformed by 33.5% as the end of September.

Dynamics of European banks was uniform in September with all members of SX7P index ended the month in the red except for Bankia, which increased by 17.6% MoM due to 20% premium to its closing price of September, 3 in the announced M&A deal with CaixaBank. The key laggards were French banks because of significant growth of COVID-19 cases in the country in September.

Despite EPS estimates of European banks have finally stopped going down, investors continue to underweight them as a recovery of EU economy has decelerated recently while the second wave of the pandemic has already begun in majority of European countries and some of them started returning restrictions. So, composite PMI was a touch higher than 50 pts, pointing to almost no growth in the last month, with services PMI well below the edge. Despite inflation remains very weak while risks remain high and markedly increased in September, ECB left its policy unchanged at the last meeting. In such circumstances, it is difficult to imagine that investors will want to have banking shares in their portfolios, especially taking into account the continuing dividends ban and negative for longer rates. Fundamentals of EU banks remain weak and will remain so in the near future while multipliers don’t look very attractive at the moment. Thus, EU banks are trading again with discount to historical averages while discount to US peers is still lower than usually. Thus, the discount to historical averages is 12% (-0.7 std at the moment from mean P/E NY of SX7P index members, sample from 2010 to the present) but the discount to US peers (on median P/E NY of BKX index vs SX7P index) is just 16.7% at the moment vs average since 2010 of 20.5%, out of synch with reality, from our point of view, given higher risks associated with EU banks which have not fully recovered from the previous crisis yet. So, we continue prefer US banks to EU ones.

Download PDF

10 July 2020, Arbat Capital

investment, banks;

Read more