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

Banking Sector Report - September 2018

EXECUTIVE SUMMARY

US banks again underperformed the broad market on MoM basis, the forth month of the last five. But, in fact, US banks were relatively flat over the last 5 months, trading in a narrow range of 103-111 points on BKX index. In September, US banks decreased by 4.8% MoM vs +0.4% of SPX index. On the YTD basis, banks still underperformed the broad market significantly by 9.8% as of end-September. Absolute September performance on MoM basis was -0.8 StD from the mean and it is in the bottom 17% of the absolute MoM performance of BKX index. Relative September performance was -5.2% MoM, it is -1.1 StD from the mean and it is in the bottom 9% of relative MoM performance vs SPX. It is the worst performance of BKX index in September on relative basis over the last 24 years. In absolute terms, it was the worst September for US banking quotes over the last 7 years. Dynamics within the sector was relatively uniform, just two out of 34 banks from our sample showed positive performance. The key underperformer was WFC which decreased by more than 10% in September as OCC rejected WFC’s remediation plan what was perceived by the market as an intensification of legal risks.

The key event of upcoming month is 3Q18 reporting season. US banks will start on October 12th, when 3Q18 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 significant underperformance of banks YTD/QoQ and relatively weak mid-quarter guidance, the street continues to revise up EPS estimates. Thus, median growth of FY2018 EPS estimates of BKX index members is +1.2% QoQ and +14.7% YTD (as of September 28). Median growth of 3Q18 EPS estimates of BKX index members was +0.5% qoq, the highest one over the last 6 years. The key driver of net profit will remain NII due to ongoing NIM expansion and mid-single digit loan growth but both drivers have been raising more and more questions among investors lately. Thus, from our point of view, further dynamics of EPS estimates will largely depends on whether banks are able to return investors’ optimism about loan growth acceleration and NIM expansion. But overall operating trends will remain benign with credit costs near multi-year highs, ongoing positive operating leverage and better efficiency with high capital adequacy and ample level of returns through buybacks and dividends.

The main attention, from our point of view, will be focused on NIM and deposit betas. At least, marked acceleration of deposit beta in 2Q18 was a negative surprise for the market. In result, median cost of interest-bearing liabilities on qoq basis increased more than yield of earnings assets, the first time in the cycle. 2Q18 movement implies approximately 48% of current deposit beta and 27% of cumulative one since the end of 2016 (based on quarterly reports of members of BKX index). Despite it, NIM was better than estimates in 2Q18 with median positive surprise for BKX index members of 0.8 bps in absolute terms. NIM of 16 out of 24 BKX members exceeded consensus forecasts and median NIM of BKX index members increased by 1.5 bps qoq and 15 bps yoy. However, median NIM estimate of BKX index members (FY 2018/2019) was almost flat in 3Q18 in spite of more hawkish Fed and two more hikes in June and September. So, the key issue before the upcoming earnings season is whether rising short end is turning from tailwind to headwind because of rising deposit beta. Banking comments on future deposit beta dynamics weren’t uniform during the last earnings season but many of them agreed that it wasn’t the end of NIM growth trend. Of course, both cumulative beta and incremental one will go up further but we don’t see significant reasons for growth of cumulative deposit beta higher than 50%, at least at the current moment due to relatively weak loan growth and still high level of excessive deposits in the system.

Loan growth still demonstrates relatively weak dynamics but it slightly accelerated vs the end of 2017, especially in C&I segment due to high M&A activity. According to the Fed H8 data, total loans increased by 4.4% yoy (as of September 26). During the 2Q18 earnings season, banks continued to express optimism on future loan growth due to strong job market, elevated consumer confidence, high corporate activity and solid economic growth. In turn, in mid-quarter guidance banks were less optimistic because of higher paydowns, still low utilization rates, increased competition from non-bank lenders and rising uncertainty (mid-term elections, escalating of trade wars). Given the fact that acceleration of loan growth was supposed to largely neutralize a negative impact of rising deposit beta on NII growth, it was not surprising that after such comments we saw a sale of banking shares.  

Despite relatively weak dynamics of banks in recent months, we continue to hold positive view on US banks with better performance than broad market in the ending months of the year. We recommend buying US banks on dips but being selective as risks are rising because of the late cycle. Key drivers remain the same - positive effect of tax reform, ongoing growth of rates, strong economic momentum, and possible deregulation, but positive effect of each of them will gradually fade and the impact of these factors on the industry will not be uniform. Overall, dynamics of operating results of US banks remains strong with high growth of revenues and profits, good cost control, high quality of loan portfolio and ample capital levels. However, banks look relatively cheap, from historic point of view, trading with -1.1/-1.2 std on P/E CY and -0.9/-1.1 std on P/E NY (on the basis of samples from 2000 and 2010 yrs to current year). As for relative to S&P 500, banks are currently trading at -1.3 std from the sample mean (2000-current moment) for both P/E CY and NY. Our top peaks are Bank of America (BAC), JP Morgan (JPM) and Morgan Stanley (MS).

After significant underperformance in August, European banks showed better dynamics in September but SX7P index continues to underperform broad market index YTD, -13.5%. In result, SX7P index is still near the 21-month low, not much higher than the pre-election level of the 2016 year. Absolute September performance of SX7P was +1.5% MoM or +0.2 std from the mean and this result is in the top 47% of absolute monthly performance of SX7P since the index inception. So, relative monthly performance was +1.3% MoM or +0.4 std and it is in the top 29% of relative monthly performance. Dynamics within the sector was relatively uniform with just 9 banks with negative monthly performance. One of key outperformers was Commerzbank which added more than 10% in September due to intensification of rumors of possible takeover by Deutsche Bank which is favorably viewed by Germany. The key underperformer was Danske bank which decreased by more than 10% as its internal investigation into Estonian branch revealed significant level of suspicious transactions.

Despite strong 2Q18 earnings season with high number of positive surprises across many lines of P&L, significant yoy growth of profits and better credit quality, European banks remains the weakest sector in Eurostoxx YTD, declining by 14.8%. Yes, large part of September gains were pared in the last trading day of the quarter because of Italian budget fears, but this does not negate the fact that the dynamics of banking shares remain weak. Of course, macro data wasn’t strong in 1H2018, trade war threats intensified while political uncertainty remains on the agenda but growth rate of European economy continues to be above potential level, capital is strong, higher rates are coming even if not in the near future but EU banks are one of the cheapest sector trading with estimated P/E 18/19 at 10.6x and 9.5x, respectively, near the lowest figure over the last 2 years. Certainly, consensus estimates of EPS will continue to go down in the near future to reflect recent negative news but we think that these risks have already been in the price and it is good time to begin forming a long position in European banks. We don’t rule out that prices may go down further but it will be an opportunity for us to increase the share of EU banks in the portfolio.

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