EXECUTIVE SUMMARY

US banks were sold off in February after they had demonstrated the most impressive start of the year since 2010. In February US banks decreased by 2.3% MoM vs -3.9% of SPX index. But banks added +5.6% YTD significantly outperforming S&P 500 which increased only by +1.5% YTD. Banks were outperforming SPX index for the past 4 months in a row. Nevertheless, it should be noted that the correlation between January performance and full year one isn’t very high, around 0.3. Absolute February performance on MoM basis was -0.5 StD from the mean performance and it is in the bottom 27% absolute monthly performance of BKX Index. In turn, relative February performance vs SPX index was +1.7% MoM in absolute terms, it is +0.4 StD from the mean and this result is in the top 32% of relative performance of BKX index vs SPX.

Correction was broad based with just 8 out of 34 banks of BKX index demonstrated positive performance. The key laggard was WFC which decreased by 11.2% MoM because of the Fed consent order related to the legacy issues which implied asset cap, third party review of the new oversight practices and replacement of four board members.

On 1 February the Federal Reserve Board released the scenarios banks and supervisors will use for the 2018 Comprehensive Capital Analysis and Review and Dodd-Frank Act stress test exercises. Bank reacted positively on it on the day of publication but then we saw flash crash on the whole US stock market. “Capital plans should be submitted to the Fed no later than April 5, 2018”. Stress test scenarios are tougher than 1 year ago with more severe recession, greater price shock for both stock market and real estate market, steeper curve and greater decline of ST rates but less severe decline in European economies. Also, it should be noted that the Fed included in the test impact of tax reform which is negative for majority of banks because of DTA write-downs (write-ups for some banks) and lower tax rate on losses in stress scenarios. Dividend cap was left unchanged at 30% despite expectations that it could be removed or at least revised up. The regulator reduced supporting documentation and slightly streamlined the CCAR process but, from our point of view, it is small positive given the optimism about deregulation and still no growth of SIFI buffer. We expect that payout ratios will markedly increase among US banks vs CCAR 2017 due to still high level of excess capital, solid profit generation and gradual deregulation.

After the Fed left federal funds rate unchanged on the January meeting, the market’s attention was focused on the FOMC minutes and Powell’s testimony which should help to see how justified was skyrocketing growth of treasury yields in the recent months. Both events were hawkish, from our point of view, so yields continued to go up – 10yr yield increased by 15.6 bps MoM in February or +45.5 bps YTD. The minutes of the January meeting pointed to more optimistic view on the labor market and the economy growth. The same view was disclosed by Jerome Powell which said that his personal outlook for the economy has strengthened since December. He also noted that some of the headwinds which US economy faced early have turned to tailwinds. Participants of FOMC committee noted “accommodative financial conditions, the recently enacted tax legislation, and an improved global economic outlook as factors likely to support economic growth over coming quarters”. As it was expected after more hawkish wording during the last meeting, the main discussion was focused on the inflation and the inflation outlook was more optimistic with staff expectations of notably faster core PCE growth vs faster one in December and majority of members expected that inflation will rise to 2% in medium term. The next Fed meeting was expected to hold only on March 21 and the probability of the rate hike on the March meeting remained at 100% while probabilities of the hikes in 2^nd, 3^rd and 4^th quarters also increased recently.

The January 2017 Senior Loan Officer Opinion Survey confirmed earlier emerging trends. C&I lending standards were modestly eased to large and middle-market firms over the past three months (the fourth consecutive quarters of easing), while standards for small firms were basically unchanged after 3 quarters in a row of easing standards. Banks continue to tighten standards for CRE loans for the tenth quarter in a row. Standards for all categories of consumer loans were basically unchanged, but standards for auto and credit cards were tightened again (the third consecutive quarter of tightening in credit cards and seven quarters in a row for auto loans). Overall, macro data remains very strong with positive surprises for majority of indicators, but loan growth continues to be anemic.

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, potential 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 robust with very healthy both revenue and net income growth trends. Our top peaks remain Bank of America (BAC), JP Morgan Chase (JPM), Morgan Stanley (MS), Comerica (CMA) and Zions Bancorporation (ZION).

In February, EU banks significantly decreased after strong start of the year. They decreased by 3.7% MoM vs -4.0% 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 into the channel. Absolute February performance of SX7P was -0.6 std from the mean and this result is in the bottom 20% of absolute monthly performance of SX7P since the index inception. Despite the decline, it outperformed the broad market index by 0.3% and it is in the top 41% of relative monthly performance vs STOXX 600 (+0.1 std).

Dynamics within the sector was mainly driven by quarterly results. The leader of the sector in February was Barclays which added 6.8% MoM due to higher divided guidance despite it missed on some operating lines. The key laggard were Deutsche Bank and Sabadell which missed the estimates and both decreased by around 10% MoM.

Eurozone continues demonstrate strong GDP growth while risks for EU economy remain broadly balanced, including recent growth of currency and FX volatility. Eurozone GDP increased by 2.7% yoy in 4Q17 vs +2.8% yoy in 3Q17 and +1.9% yoy in 4Q16. Recent macro indicators confirm strong momentum in European economy with ongoing growth of PMI, better than estimates industrial production and further improvement of EU consumer health with continued solid growth of consumer spending and employment. Economic sentiment is improving further after the ECB meeting in December, reflecting more positive expectations for growth of EU economy.

EU yields markedly increased in the recent months 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. The nearest risk for EU banks could be Italian elections which will be held in the early March.

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15 March 2018, Arbat Capital

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