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Banking Sector Report - January 2017

EXECUTIVE SUMMARY

US banks added 1.7% YTD in January (the closing price on Friday, January 27) vs. +2.5% of SPX. It is the fourth month in a row of positive performance of US banks, but momentum is fading despite improving macro data. The best performance was showed by Signature (SBNY), Suntrust (STI) and Bank of America (BAC), each of which added more than 5%. The worst performance was demonstrated by Northern Trust (NTRS), New York Community (NYCB) and Bank of New York Mellon (BK), each of which decreased by more than 4%. The key January driver of US banks was quarterly earnings and guidance on 2017 year.

For the first time in 4 months US banks underperformed SPX index, -0.8% YTD. It is not surprise for us, as we think that too much optimism was incorporated in US banking stock prices recently. Moreover, we recommended to sell US banks vs. SPX index in our previous report. And we are still convinced that this trade remains in the game despite good quarterly results of US banks and positive guidance on 2017.

As for us, the key event of the last month was US reporting season. It was the first opportunity to test how indeed positive for operating results were the main drivers of the recent outperformance of US banks, when BKX index outperformed SPX index almost by 16% for the period from the election until the beginning of the reporting season. After the election, banks grew skyrocketing on a number of drivers: lower taxes, changing regulatory environment, rising rates and expectations of the acceleration of economic growth.  Technically, tax and regulatory drivers are too remote in time from us, although the number of banks significantly improved their results due to the relatively low rates. But rising rates and increased confidence in economics growth have already begun to influence positively on banking profits.

From EPS surprises point of view, it was a good quarter despite upward revision of 4Q EPS estimates during the quarter, +1.75% median EPS revision for 24 largest US banks. It was the first quarter in more than two years with positive revisions to quarterly estimates. For example, 4Q15 EPS estimates were revised down by 4.2% during the 4Q 2015 year. More than 70% of reported banks managed to beat consensus expectations. The strongest surprises were shown by Goldman Sachs, Morgan Stanley, JP Morgan and Zions Bancorp. The latter beat was driven by lower provisions and higher NII. JPM, GS and MS surprises mainly associated with strong trading results, especially in FICC, good cost control and relatively low tax rates. So street started to actively revise EPS estimates for 2017 & 2018 yrs, median current year estimate was revised up by 1% (as of 24 Jan), the strongest start for more than 10 years.

As for taxes and regulatory relief, there was mainly streamlined language about possible influence on the bottom line. BBT noted that it could absorb around 90% of tax decrease, while USB mentioned only about 50-60%. Moreover, we should remember about possible overlap, for example removing of tax deductibility, what could reduce positive implication of tax decrease even lower. In any case, it is not even of near future event, more probably late 2017 or even 2018 one. As for regulatory changes, majority of comments were treated to SIFI buffer increase. Mid-cap banks noted that they could be able to increase capital returns in this case. But even significant regulatory changes will not decrease regulatory costs dramatically and, in any case, it will take considerable time.

Overall, it was really good quarter. Banks have shown nice results and if there weren’t significant outperformance in previous months, we could count on a good dynamics of prices on these results. But now investors are trying to evaluate how justified were the recent growth as multiples still remain very high. The latter argument forces us to follow cautious short-term view on US banks. But our long term view became much more positive after the earnings season and we would be buyers of US banks in case of 10-15% correction of BKX index. In any case, we prefer Large caps to Small caps because of their lower multiples.  

In December EU Banks continue to grow, the fourth month in a row. SX7P index added 4.6% vs. 1.4% of STOXX 600 Index (the closing price on Friday, January 27). The best performance was demonstrated by UBI Banca (+36% YTD) due to announcement of acquisition of 3 small Italian banks from Italian national resolution authority for €1. The worst performance was demonstrated by Intesa Sanpaolo, -6.5% YTD because of rumors about purchase of Generali.

Macro data released in January indicates that slow and steady economic growth will continue. Consumer confidence continues to grow and it is near the highs for more than 8 years. Markit PMI indicators for EU are also near the all time high. November Industrial Production is 1.5% (beats the estimates) vs. -0.7% year ago. Taking into account falling euro as competitive advantage, good correlation of EU GDP growth and US GDP growth, it is absolutely not surprising for us that consensus GDP forecasts for EU continue to grow.  EU GDP 2017 growth estimates increased by 6bps in absolute terms during the last month (to 1.48%). EU GDP growth forecast also rose by 6bps to 1.56%.

Bloomberg EU economic surprise index is currently at the highest level for 2 years. Bloomberg US economic surprise index is at the highest level for more than 4 years. The same is true for the Global surprise index. Taking into account significant depreciation of the euro, acceleration of growth in US and Global economy, we think that there will be also acceleration of EU GDP growth given relatively close connection of EU and US economies(not immediately but in the foreseeable future).

But in any case, the key February event for EU banks will be earnings season and it seems that we will see many positive surprises as 4Q16 earnings estimates growth was relatively sluggish despite strong results in 3Q16 and skyrocketing growth of yields throughout the world. At least, the start of earnings season confirms this idea with beats from Santander, UBS, Nordea and Bankinter.

Although the operating results of the European banks and macroeconomic indicators showed a positive dynamics recently, we do not expect that the quotes will continue to grow in the coming months because of significant outperformance during last 4 months. At least, discount on multiples between EU and US banks decreased to minimal levels for more than 5 years due to recent spurt of European banks given the fact that US banks also grew significantly. And we think that it was too fast and too early growth.

Relative outperformance of SX7P vs. STOXX 600 index in January is 3.2% and it is in the top 13% relative monthly performance vs. STOXX 600 since the inception (+1StD). As for current 4 month spurt of SX7P, it is the fourth best relative outperformance result in the history, +19% or +2.5 StD from the mean. Usually, stocks correct after such strong growth.

Taking into account busy political calendar and high valuation, we are cautious on EU banks near term. Of course, accommodative monetary policy of ECB should help the European economy to go through upcoming political events without significant losses. But currently we see value only in Italian banks among European banks; however it doesn’t mean that they will grow when other EU banks go down.

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