HomeResearch and NewsBanking Sector Report - March 2018
Mikhail Zavaraev CFA, Senior Analyst
Report

Banking Sector Report - March 2018

EXECUTIVE SUMMARY

US banks finished the quarter in the red zone (-0.2% ytd) despite in January they demonstrated the most impressive start of the year since 2010. In March banks lost 5.5% MoM vs -2.7% MoM of SPX index, after -2.3% MoM decline in February. Banks significantly underperform broad-based index in March, after four consecutive months of outperformance. Absolute March performance on MoM basis was -0.9 StD from the mean performance and it is in the bottom 14% absolute monthly performance of BKX Index. Relative March performance is -0.6 StD from the mean, and this result is in the bottom 19% of relative performance of BKX index vs SPX. Correction was broad based with just 2 out of 34 banks of BKX index demonstrated positive performance. The key laggards were WFC, which decreased by 10.6% MoM because of ongoing legacy/regulatory issues, and C, which decreased by 10.3% because of high exposure on trade wars risk.

The Senate finished considering the bipartisan banking reform bill championed by Senator Crapo on March 14. The full name of the bill is “Economic growth, regulatory relief, and consumer protection bill” and it raises SIFI threshold from current $50 Bn to $250 Bn and relaxes/removes parts of Dodd-Frank act (mainly for small banks with assets less than $10 Bn.). Of course, it should also be approved by both the House and the President. Possibly, we will see some changes in the document after that, but, in our opinion, the first and very important step has already done. From our point of view, it means that process of active deregulation, which should be very important driver for banking stocks in the near years, has already started. At least, small and mid-sized banks will be able to increase capital returns, decrease some regulatory-related costs, focus more on growth, including through M&A deals.  

The key event of the coming month will be the earnings season which will start on April 13th, when 1Q18 quarterly reports are provided by JP Morgan Chase, Citigroup and Wells Fargo. After that, within two weeks, all members of BKX index will provide the quarterly results. Despite the fact that US banks declined markedly after very strong start of the year, the street continues to revise EPS estimates of the financial institutions up. Median growth of 1Q18 EPS of BKX index members was +9.8% ytd, just the second positive revision for 1Q EPS estimates in the last twelve years (median revision for this period is -1.4% qtd / average is -4.8% qtd). Full-year estimates for the current and next years were also revised up significantly. Median growth of CY EPS estimates of BKX index members is +10.9% ytd vs average figure for the last 12 years of -4.5% in the first quarter of the year. The same picture is also observed for EPS estimates of the next year. The key driver of the strong positive revision of EPS estimates, from our point of view, was the tax reform which was signed by the President Trump just few days before the New Year, so the effect of the reform was not taken into account in all estimates before the end of last year. Also, interest rates remains very important driver for bank’s revenues with two hikes since the early December, the more hawkish Fed and significant growth of the long end given still very low deposit beta vs the previous hike cycles. We expect that the street will continue to revise up estimates further due to more hawkish rate outlook, acceleration of loan growth, stronger growth of the economy and the positive effect of expected deregulation.

Overall, the operating trends of US banks remain strong with high growth of revenues and profits, good cost control, high quality of loan portfolio and ample capital levels. Decelerating loan growth is no more a headwind for the industry, while tax reform will still has a significant positive impact on the industry. Direct impact of the reform is in price, from our point of view, while the second order effects and more hawkish pace of rates dynamics aren’t. We expect that banks will continue to show more positive surprises than negative ones, as they did in 36 consecutive quarters before, even despite very strong growth of EPS estimates ytd.

Banks stocks slightly underperforming index during the correction followed the January meeting as the market was afraid of possible negative effect of rising rates on growth of the economy. Also, it tried to estimate the risk of the imposed tariffs and negative effects of possible trade wars. From our point of view, the long period of no deep correction was also a reason for sell-off. However, we think the probability that next 3 or 4 rate hikes could slow economic growth is low given strong momentum and positive impact of the tax reform. We are convinced that rising rates will continue to positively impact on banks' revenues with no significant impact on the quality of the portfolio and its growth rates. Possibly, we will see negative impact of rising rates in 2-3 years in case of the same speed of rate hikes.

We continue to hold the view that US banks will outperform broad market and recommend to buy their shares on dips as positive effect of tax reform, rising rates, strong economic momentum and possible deregulation will continue to positively impact both on banking operating results and quotes dynamics. Moreover, banks no more expensive, from historic point of view, trading with -0.1-0.2 std on P/E CY and NY (on the basis of samples from 2000 and 2010 yrs to current moment). As for relative to S&P 500, banks are currently trading at -0.9 std from the sample mean (2000-current moment) for both P/E CY and P/E NY. From our point of view, it good moment to buy US banks. Our top peaks are Bank of America (BAC), JP Morgan Chase (JPM), Morgan Stanley (MS), Comerica (CMA) and Zions Bancorporation (ZION).

In March, EU banks significantly decreased after marked drop in February and showed quarterly decline of 5.9% qoq despite strong start of the year. They decreased by 6.9% MoM vs -2.3% of STOXX 600 Index. In late January EU banks finally went from the narrow sideway channel up, in which it was trading for more than 8 months (175-191 pts on the SX7P index), but after that the growth of index didn’t accelerate and they quickly went back to its 15-month lows. Absolute March performance of SX7P was -1.1 std from the mean and this result is in the bottom 12% of absolute monthly performance of SX7P since the index inception. It also underperformed the broad market index by 4.7% and it is in the bottom 9% of relative monthly performance vs STOXX 600 index (-1.3 std). Dynamics within the sector was uniform with only one bank with positive MoM performance (Kommercni Banka). The key laggards were German Commerzbank and Deutsche Bank which decreased by 17.2% MoM and by 14.2% MoM, respectively.

The key reasons of the correction are fears about US trade tariffs which could transform into trade war and become a reason of global slowing. All the more so as recent European macro data wasn’t strong with significant decline of economic surprise indexes. But, from our point of view, Eurozone continues demonstrate strong GDP growth while risks for EU economy remain broadly balanced. Eurozone GDP increased by 2.7% yoy in 4Q17 vs +2.8% yoy in 3Q17 and +1.9% yoy in 4Q16. Consensus for GDP growth in 2018 is 2.4% yoy at the moment, increased by 20 bps from +2.2% yoy 2 months ago. ECB also remains optimistic: “Incoming information, including our new staff projections, confirms the strong and broad-based growth momentum in the euro area economy, which is projected to expand in the near term at a somewhat faster pace than previously expected”. Staff projections of GDP growth were marginally revised up. It should be also noted that EU banks look more expensive both vs historic averages and vs US peers, trading with 16% discount to US peers vs historic average of 23% or +0.7 Std, despite they have higher risks and worse operating efficiency. Currently, we prefer US banks, but expect that EU banks will follow US peers and they will also outperform the broad based EU market in 2018 however it will be a bumpier road for them, from our point of view.

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