13th January 2019

Now comes the hard part | Bank Capital Insights

Will forthcoming bank earnings help or hinder risk sentiment?

Last week was a good one for risk assets especially in bank capital (and within that AT1) driven by dovish Fed speak, trade war resolution optimism and no new “unknowns” to rattle investors.  Add to that the lack of supply in high yielding paper in bank capital land and the result was a sharp rally.

But seasoned investors would have also noticed that none of the underlying issues impacting European banks have gone away (slow growth, margin pressure, liquidity pressure, high cost base) and hence caution is probably the next best strategy here.

So what now?  Is this the beginning of a new risk on phase or just another false dawn…

Starting on Monday, the large US banks will report Q4 earnings and set out their outlook for the next few quarters.  To me, the Q4 numbers are a bit irrelevant and it is the commentary and tone at the press conferences that will dictate price action.

Bank CEOS are going to be pushed around on a number of key issues that are of importance to investors including:

  • State of play in the leveraged loan markets and consumer finance business
  • Impact of higher funding costs on margins
  • Credit costs and loan loss reserve build up
  • Impact of tightening financial conditions on lending
  • Markets related activity especially in FICC
  • Cost reduction plans to offset revenue slowdown
  • Capital distribution plans

The post-earnings stock price reaction will set the overall tone for financials and more importantly for European banks.  If the US banks cannot meet the expectations, what chance do the Europeans have?


GS may report advisory revenues higher than FICC?

Staying on the US banks, we had FT report that Goldman Sachs’s advisory revenues may be higher than FICC revenues, the first time in the last 10 years or so.

But to me the bigger issue still remains the same (and that is true for all investment banks) – generating ROE in excess of COE is difficult in FICC given the:

  • Balance sheet intensive nature and need to warehouse;
  • Heavy investment in technology / automation (which tends to be lumpy and pays over time);
  • Shrinking revenue wallet given lower secondary market volumes;
  • Regulatory requirements for capital and liquidity; and
  • Cost of funding a highly cyclical business

Even if a bank is able to manage the above and be profitable, all it takes is one regulatory or operational risk event which results in high settlement costs.

Hence it is difficult for investors to figure out what multiple to pay for such businesses and to some extent, I see them as value traps.

I still think it is better to own banks with pricing power in retail/commercial banking and with a low-cost base and flexible enough to adjust to downturns.


European bank headlines

We had a number of press headlines over the weekend which justify our ongoing cautious play and the importance of single name selection.

  • FT says BNP Paribas to shut down its proprietary trading unit (apparently it has EUR 600 million of capital). The surprise is how did they manage to keep it going for such a long time given the regulatory background?
  • Bloomberg says Danske Accused of ‘Openly Lying’ to Investigators in France – it seems that this problem will become bigger before it settles?
  • Bloomberg also reports Deutsche Bank, Finance Ministry Held 23 Talks as Woes Worsened – will the negative news flow ever end for this bank?

Whilst European bank AT1s may be yield attractive, I believe careful single name selection is still key and hence better to own the retail/commercial banks with a transparent business model and sound risk management framework. Any positive resolution on Brexit will mean that the UK bank AT1s are starting to look very attractive indeed.


Conclusion:

US bank earnings will set the tone for risk appetite for financials but volatility will be at play on Brexit related headlines.  Any positive event risk may see bank capital instruments enjoy a further rally, especially for US and UK banks.

But that it is where it stops as I think the Euro Zone banks have many more underlying issues to contend with and hence need much more careful deep-dive analytical work   It is too early to give the all clear and rush to own anything that has yield.   A rising tide may lift all boats but think about what can happen if the tide recedes.


Look out for my next trade idea in our next Friday note….

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GJ Prasad

A senior European bank research specialist with significant breadth/in-depth sector knowledge, GJ has researched bank capital instruments extensively - having covered the asset class for more than 15 years as an analyst and 7 years as a risk taker in buy-side roles. His specialisation includes carrying out detailed financial modelling work on the European banks focusing on asset quality, earnings and capital adequacy metrics. His deep-dive work focuses on single name selection and extensive risk analysis on capital securities, especially on structural features, issuer credit profile and equity/AT1 valuation.