EXECUTIVE SUMMARY

In December US Banks (BKX index) increased by 2.0% MoM vs +1.0% MoM of S&P 500 index after slight outperformance in November. Despite strong growth of banks quotes in the last four months (+14.8% in absolute terms) SPX index outperformed it during 2017: +19.4% vs +16.3% of BKX index. Absolute December performance on MoM basis was just +0.2 StD from the mean monthly performance and this result is in the top 44% of absolute monthly performance of BKX Index. Dynamics of the sector was mainly driven by approval of the tax reform, so the most impressive growth was shown by consumer finance companies which had the highest effective tax rate among US Finance sector.

The Fed increased the target range for the federal funds rate by 0.25% to 1.25% to 1.50% as it was widely expected (the market had estimated probability of it at almost 100% in early December). The policy statement had few changes. The key of them, from our point of view, related to evaluation of core inflation and more optimistic economic forecasts. The dot plot continued to imply three hikes in 2018 (as it was in 2017) and two hikes in 2019 and two more in 2020. The market priced currently just around 2 hikes. Due to still very low deposit beta, the number of hikes is very critical for almost all US banks, especially for the most asset sensitive ones. We expect 3 hikes in 2018 (but we believe it possible that the number of hikes could be more) and it seems, from our point of view, that not all of these hikes has currently priced in. However, the flatter yield curve is starting to bother us even despite the short end is more important for majority of US banks as it could negatively impact on bank’s top line in the future. The Fed significantly increased the economic projections. It shouldn’t be perceived as surprise after changed wording from “moderate” to “solid” at the previous meeting. But the size of upgrade was a positive surprise for us, at least estimate of GDP growth in 2018. The estimate of GDP growth for 2017 year was revised up by 10 bps to 2.5% (from September projection); for 2018 year by 40 bps to 2.5%; for 2018 by 10 bps to 1.8%; for 2019 year by 20 bps to 2%. Currently, consensus estimates implies that median NIM of BKX index will increase by 7 bps YoY in absolute terms in 2018, but given the current dot plots and the forward yield curve, NIM growth could exceed 10 bps in 2018.

Tax reform was signed by President Trump just few days before the New Year. It was widely expected event but there had been a chance that it could happen later. In any case, the tax reform is very positive for US banks and it will be one of the main drivers of bank EPS in the near years. The key benefit for banks is lowering of corporate tax rate from 35% to 21%. Moreover, the new tax rate will already be effective in the fiscal year 2018. In turn, eliminating of FDIC fee taxability and need to write down DTAs (for some banks) will negatively impact on both EPS and capital (temporary effect). But on the net basis, median growth of banks EPS will exceed 10% and that's without taking into account the secondary effects of the tax reform. Even despite the fact that the event was widely expected, the full effect of the reform isn’t in consensus estimates of EPS yet, from our point of view.

Deregulation is the most critical issue for banks in the current year as it could be a very important driver of growth of both banking EPS and ROE and we are convinced that deregulation isn’t in price yet. Deregulation will give banks more capital flexibility. From our point of view, the most important consequence of deregulation could be M&A acceleration, especially among regional and super regional banks in case of rising of SIFI limit from $50 bn to $250 bn. So, we will see further multiples expansion.

Loan growth at US banks decelerated since September 2016 to its local low of 3% yoy in the end of August 2017. But after that total loan growth accelerated to 4.2% as the end of 2017. The key driver of weak loan growth was C&I which growth rate decreased from 9.1% yoy in October 2016 to 0.7% yoy in the early December 2017 (+1.6% yoy as the end of 2017). But we expect that C&I loans growth will accelerate from the current level due to faster growth of the economy and pick-up in CAPEX. We don’t expect that total loan growth accelerate to the mid-cycle growth rate but we expect that it will not be a drag for banks operating results in 2018 as it was in 2017. We also think that quality of the loan portfolio of US banks will remain strong in 2018 with only slight increase of both NCO ratios and provisions even despite some red flags in Auto and Credit Cards lately.

From our point of view, it is highly likely that US banks will continue to outperform broad market in 2018 due to net positive effect of the tax reform, higher rates, expected growth of total payout ratios during CCAR and continuation of the deregulation process. Multipliers don’t look cheap but relative to S&P 500 index banks don’t also look expensive. We expect that credit quality will remain strong (except for some consumer areas) while loan growth rate will accelerate due to faster growth of the economy and pick-up in CAPEX. Overall, operating results of US banks remain strong with very healthy revenue and net income growth. Despite we don’t expect strong figures during the 4Q17 earnings season because of tax reform related one-timers and relatively weak trading results due to still weak volatility, we wait for double-digit EPS growth of US banks in 2018 year. Currently, consensus estimates of median EPS growth of BKX index members are 22% yoy in 2018 and 12% in 2019.  Our top peaks are Bank of America (BAC), JP Morgan Chase (JPM), Morgan Stanley (MS), Comerica (CMA) and Zions Bancorporation (ZION).

In December EU Banks increased by 0.9% MoM vs +0.6% MoM of STOXX 600 index. It was the second consecutive month of positive performance of EU banks but SX7P Index ended year lower than it was at the end of October. However, banks managed to outperform broad based index by +0.35% in 2017. Notwithstanding, EU banks continue trading in the narrow sideway channel for more than 8 months (175-191 pts on the SX7P index). Dynamics of European banks wasn’t uniform in December. The key underperformers were Italian banks because of strong performance in November, uncertainty with upcoming elections and risk of more serious pressure from regulator for more aggressive NPLs reduction. Among banks with the best performance were CYBG, ABN, STAN, UBS and BARC (largely due to positive outcome of Basel 4, Brexit negotiations and US tax reform).

Steady economic expansion in the euro area continues with GDP YoY growth markedly higher than 2% and recent macro data indicates that it will remain solid in 2018. At least, ECB significantly increased its GDP forecasts at the last meeting. Last macro figures confirmed this point of view. ECB’s GDP growth forecast for 2017 year was revised up from 2.2% to 2.4%, for 2018 from 1.8% to 2.3%, for 2019 from 1.9% to 1.7%. Composite PMI, which is well correlated with GDP growth, markedly increased in December after strong growth in November and it remained at multi-year high. Preliminary composite index increased by 0.5 pts to 58.0 pts, well above consensus estimate of 57.2 pts.

EU yields markedly increased in December and the yield curve continues to become steeper and steeper turning to be a tailwind for European banks along with strong macro figures and growing profits. Lower regulation headwinds, less political uncertainty, stronger loan growth and decreasing NPLs also continue to contribute to the further growth of banking quotes given not very rich valuations for many of EU banks yet. We expect that EU banks will follow US peers and they will also outperform the broad based EU market in 2018, but the road of EU banks will be more bumpy because the short end of the curve will not change significantly in the near future even despite the strong growth of EU economy while a part of future rate hikes have already priced in, from our point of view. Our top pick in EU is UCG with the price target of €22 at the end of 2018.

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18 January 2018, Arbat Capital

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