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Banking Sector Report - December 2016

EXECUTIVE SUMMARY

In December US banks continue to grow rapidly. US banking Index (BKX) added 6.7% vs. 3.0% of S&P 500 Index (the closing price on Friday, December 23). Current absolute December performance is +0.9StD from the mean monthly performance since the 1992 and this result is in top 15% absolute monthly performance of BKX index.

Current relative outperformance of BKX index, 3.7%, is in the top 20% relative monthly performance of BKX Index vs. S&P 500 index. November relative outperformance of BKX was significantly higher, 13.3% or +2.8StD from the mean, the third best result in the history. There are 9 cases in history, when monthly relative performance of BKX Index was higher than +2StD from the mean. After that BKX index usually showed negative 12- month absolute performance (6 of the 9 cases) with the average performance of -15%. And mixed December dynamics of US banks is the first sign of fading current momentum, from our point of view.

Macro statistics continue to remain supportive for US banking operating environment with ongoing growth of yields, positive stance of the FED and so far relatively healthy loans growth. However, corporate loans growth continue to decelerate and the question is whether consumer loans will be able to replace the slower growth in the corporate segment.

Technically, it is possible that we will see acceleration of corporate loan growth due to lower taxes and infrastructure spending in the near future. At least, December Empire manufacturing showed the best growth in five years. However, despite growing business optimism, we remain cautious in terms of prospects of corporate lending as see skyrocketing growth of rates and tightening lending standards for five consecutive quarters. Management of the banks doesn't share our pessimism and they noted at the last GS Financial conference that corporate segment is in good shape except for energy portfolio.

Post-election optimism is reflected in the forecasts of operating results for the 4Q - median quarterly EPS growth is 10.4% for our group of banks (Bloomberg consensus vs. actual 4Q15). Due to ongoing growth of rates median 4Q EPS is 1.4% higher QTD but anyway it is -7.8% YTD - typical picture for all recent years. There should be good figures in NII and capital markets revenues. But in any case, from our point of view, the market will focus on the management's comments, not on the actual figures and possible positive surprises as the key question for the market is whether banks see increased activity ahead of economic incentives of the new President or recent rapid growth of rates caused clients to wait and see. On the last GS financial conference the management of most banks were quite conservative in their estimates of new initiatives. The common theme of the statements was similar to the following - It should be very positive for the industry, but it is better to wait for the news than to talk about the rumors.

Trump's triumph and Republican sweep were a game changer for investors’ perception of the banks stocks, but the key question for us is whether it will be a game changer for banks operating results in the same way as the dynamics of quotations in the last two months. Surely, rising rates, lower taxes, possible deregulation and moderate acceleration of the economy are the tailwinds for banks revenues. And currently consensus EPS estimates are far too slow for quotes. Despite the fact that in the bull case EPS of some banks could grow by 40-50%, median EPS forecasts for 2017 and 2018 years increased by only 2.2% and 2.9% respectively since the end of October. At the same time BKX index have already added more than 25%, which roughly corresponds to possible median EPS benefits for our group of banks in the bull case.

As a result, absolute forward P/E multipliers are close to their 20-yr highs. Median P/E 2017E, is 15.2x, 25% higher than mean or +2.5StD (sample from 2000). The same figures for P/E 2018E 13.9, 29% higher than mean or 1.9StD. Moreover, the history of last two periods of rate hikes suggests that multipliers and even NIM should go down during rate hike cycle. The current situation may be different because of low loan to deposit ratio and no need to switch to more expensive funding. But fact is fact.

Consensus price targets are also do not support idea of further outperformance of the US banks. Recently, median upside of our group of banks turned negative for the first time since 2013. Current differential of upsides between S&P 500 index and BKX index is 8.9% or slightly higher than +1StD for the sample from the 2005. There were 275 cases in history when this differential was higher than 8% and after that SPX outperforms BKX on 1yr horizon in more than 90% of cases with the median outperformance of 20%.

We remain cautious on US banks at these levels and recommend to sell them vs. S&P 500 index in 1H2017. From our point of view, too much optimism was incorporated in banking stock prices. We think that at the moment market tries to focus only on the positive sides of the Trump's initiatives and it doesn't carefully consider potential risks.

In December European banks continue to grow, the third month in a row. SX7P index added 8.5% vs. 5.3% of STOXX 600 index (the closing price on Friday, December 23). Absolute December SX7P performance is 1.2 StD from the mean and this result is in the top 8% absolute monthly performance of SX7P since the index inception. Relative outperformance of SX7P (vs. STOXX 600) is in the top 15%. Due to recent outperformance EU banks were almost able to close the underperformance gap which sometimes was more than 20% during the current year. Relative outperformers were Italian banks, which seriously underperformed in the November because of fears about results of Italian referendum. Despite the negative results of Italian referendum, Italian banks were able to show good performance because of "sell on the rumors, buy on the news" trading.

The ECB was able to surprise the market at the last meeting. The Governing Council announced that monthly purchases would be reduced from current €80bn to €60bn and the program would be extended through the December 2017. The ECB has also indicated a willingness to continue the current policy, if the goals aren’t achieved. For us it simply means preservation of low interest rates policy for a long period (a few years of no growth in the basic rate) and, as a consequence, continued pressure on net interest margins and NII as rates continue to fall. Average interest rates on new corporate loans continue to decline. Average EU rate decreased by 2bp in October (-21 bp YTD). Average EU rate on new consumer loans also continue to decline in October, -7 bp MoM and -13 bp YTD.

Macro data released in December indicates that slow and steady economic growth will continue. Unemployment rate (October) were 9.8% vs. estimates of 10%. October industrial production missed estimates but already December Manufacturing PMI figures beat estimates, 54.9 vs. 53.7. (4 consecutive months of growth). December consumer confidence also was better than expectations. So, the street marginally increased estimates of GDP 2017 growth by 10bp (from 1.3% to 1.4%) during the last month.

The falling Euro, still low energy prices and expectations of accelerating growth in the U.S. should have a positive impact on the growth of the European economy next year, despite a busy political calendar. A steeper yield curve is also positive for banks, nevertheless the fact that growth rates have been concentrated mainly on the long end of the curve and rates on new loans continue to decline. Deregulation also should be positive for some European banks. It is important how will be resolved Italian NPLs problem, but the resolution without much damage to junior bondholders will be positive for them and we will be buyers of UniCredit in this case. Other European banks look expensive after strong performance in past 3 months, but we will be buyers of EU IB, BNP Paribas and Raiffeisen Bank International in case of pullback in prices in the beginning of the next year.

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