Financial Services: Banks Can't Rest Easy
The macro economy remains generally benign, but banks continue to strive for increased operational and capital efficiency.
The global financial services sector appears to be fairly valued. The overall sector trades at a price/fair value ratio of 1.03, which suggests bargains are limited. The cheapest subsectors are Global Banks, Regional European Banks, and Diversified Insurance firms with an equal-weighted by company average, price/fair value ratio of approximately 0.97.
Americas Financials Update
By Eric Compton and Jim Sinegal
Several key themes are emerging lately for U.S. banks. They include low repricing of deposits despite generally rising U.S. interest rates, continued efforts to improve operating efficiency, increasing capital returns to shareholders, and marginally slower loan growth. The large universal U.S. banks also are seeing a likely reduction in third-quarter trading revenue.
We believe investors should not overreact to these short declines in loan growth or trading revenue. As for trading, volatility may have remained low over the summer, but we don't expect markets to remain calm forever. At the same time, a tight rein on expenses across the industry in recent years should pay off once volatility returns. For loan growth, once uncertainty abates surrounding key proposals in Washington, such as those related to tax reform, we believe commercial investment and mergers and acquisitions should pick up.
Many of the banks are confident that relatively low repricing of deposits, or deposit betas, will continue to hold for the immediate future, but we've already started to see repricing in accounts for more interest rate sensitive customers, such as commercial clients and high-net-worth individuals. We believe that low betas cannot stay forever. Eventually competition will have to pick up. As a result, we forecast that betas will begin increasing in 2018, and net interest margin expansion will begin to slow somewhat, but will still occur amid slow but steady rate increases over the next several years.
Many banks continue to close branches and invest in digital initiatives, leaving room for banks to keep improving operating efficiency over the medium term. We project nearly all banks under our coverage improving their cost/income ratios over the next several years as this trend plays out. Additionally, margins should remain steady to up, even with slower loan growth.
Finally, the push toward lower common equity Tier 1 ratios also remains a key theme, as banks attempt to more efficiently use their capital, improve returns on tangible equity, and return excess capital to shareholders following excellent Comprehensive Capital Analysis and Review results from the U.S. Federal Reserve. As an example, we expect undervalued Citigroup (C) to return 10% of its current market capitalization to shareholders in the form of dividends and repurchases over the next 12 months, with dividends likely to account for a larger share of that total over time. This more efficient capital base will be another key item helping U.S. banks to improve returns on equity over the medium term.
While some of the banks will be affected by the recent destruction from the hurricanes in the Southeast of the United States, costs should be manageable, and many losses will be covered by insurance. For the large global and national primary insurance carriers that we cover, we don't foresee losses from the hurricanes materially affecting their intrinsic value, as their homeowners insurance exposure to those regions is relatively small compared with their overall book of business.
Asian Financials Update
By Iris Tan, Mari Kumagai, and Michael Wu
China Banks: Chinese banks under our coverage are trading at 1.08 price/fair value after a strong rally year to date in 2017 on better investor sentiment in the Chinese market given expectations for lower financial risks and a stabilizing economy. However, we think the improved macro fundamentals are largely factored in, and we have a less optimistic long-term view for China's financial industry than the market. Thus, we currently have no 4- or 5-star recommendations. With the general trend in financial deleveraging continuing, we see increasingly divergent performance among the banks we cover.
There were a number of trends in the first half results worthy of highlighting. Net interest income, or NII, was still under pressure despite stronger loan growth in the first half. Net interest margins, or NIMs, continued to shrink due to ongoing interest rate liberation, tighter financial market liquidity, weak credit demands, and a flight to quality corporates. However, some banks with stronger deposit bases saw NIM decline bottoming out thanks to credit mix shifting toward retail loans and private sector loans and the benefit from rising interbank rates as net lenders in the interbank market. Some banks with larger exposure to overseas banking businesses saw stronger-than-peer growth in NIM and loan balance, thanks to a recovery in exports and fast overseas expansion of Chinese enterprises.
Fee income growth is more divergent, as some banks with large exposure to the asset management business (bank wealth management products and agent sales of other financial products including insurance, mutual funds, and trust products) saw a sharp contraction as a result of regulatory tightening in the asset management market in the first half. Banks with large fee income contribution from payment also saw rising threats from fintech competitors in the payment field. Meanwhile, fee income from bank card and investment bank-related services saw resilient growth.
The improvement in operating efficiency was suspended in 2016 as a result of revenue contraction, but the improvement resumed for some banks, which saw recovering topline growth in first half. The rapid pace of banking digitalization and network upgrade/repositioning, together with recovering topline growth in the following quarter are likely to translate to improving operating efficiency in the near term.
Credit quality has been showing signs of stabilization at the current stage while banks are keeping credit costs at a high level. Credit quality pressure is also diverging among banks. Large banks with prudent operations and credit exposure to lower-risks sectors (government-led infrastructure, retail and private sectors) are seeing less risks as financial deleveraging and supply-side reforms are showing some progresses. Other banks with lower-than-peer provision level, or higher credit exposure to oversupply industries, some state-owned enterprises, and mid-sized enterprises with weaker credit quality still face strong provision pressure. This trend is likely to persist as economic restructuring deepens.
Hong Kong Banks: The Hong Kong banks posted generally strong first-half results with higher-than-expected loan growth and improved net interest margin. However, we do not expect the same magnitude of growth in the second half.
Hong Kong banks' net interest margins benefited from higher interbank rates earlier in the year, but interbank rates have since declined, due to the high level of liquidity in the system. One-month and three-month HIBOR are currently at 42 basis points and 76 basis points, relative to a high of 75 basis points and 1% early in the year. Similarly, six-month HIBOR has also declined by around 30 basis points to 0.96%.
Furthermore, the high level of competition and a flight to quality corporates continue to pressure credit margins, and we do not see this alleviating in the near term. We maintain our view for net interest margins to be flat for the full year and that benefits from rising U.S. interest rates at the Hong Kong banks will not be immediate and likely in the medium-term.
System loan growth was strong in Hong Kong, mainly driven by loan demand for activities outside of Hong Kong, as Chinese corporates continue to expand offshore. Bank of China Hong Kong (02388) was the largest beneficiary, notching above system loan growth, and we expect the bank to maintain above peers' loan growth, supported by its recent acquisitions of its parent's Southeast Asian assets.
We expect the more domestically focused Hang Seng Bank (00011) to track system loan growth, while the more risk-conscious Bank of East Asia (00023) should see more moderate loan growth in the second half. With a generally positive Hong Kong economy and economic activities in China picking up late last year and sustained early this year, all three banks saw steady or declining non-performing loans. We expect lower nonperforming loans to be sustained in the second half and Hong Kong banks to fare well even if economic conditions soften, given their strong capital positions.
Japan Banks: Most of the major Japanese banks are fairly priced, although some names trade at a 10%-20% discount to our fair value estimate due to factors specific to the bank.
During the third quarter thus far, major Japanese banks are likely experiencing lower-than-expected performance as a sharp increase in geopolitical tensions result in a more challenging operating environment for banks, as the market has lower risk appetite, as there is more precautionary savings, as there is a pause in rising interest rates, and as yield curves flatten globally.
The market has already incorporated lower earning guidance for 2017, with core business earnings declining about 5%-10%. Net interest income is continuing its downward trajectory and fee income should remain flattish from increasing pricing pressures.
We also expect low interest rates in Japan. Ten-year government bonds are tracking below 10 basis points over the past two years, and they will likely remain near zero as part of the government's strict debt management policy. We continue to expect that Japan will remain in a “government debt trap.” With the Bank of Japan's yield curve controls having extended the timing required for an eventual exit from quantitative easing, we expect that Japan will keep interest rates low for a few years longer, unlike other major markets.
In the next month, we expect weak quarterly earnings as tailwinds from capital markets earlier in the year dissipate in the second half. Lingering effects from the negative interest rate implementation by the Bank of Japan since February 2016 are likely to stay at least for another 18 months, as interest rates are expected to remain low relative to comparable historical rates.
We expect slightly lower net interest income for domestic loan portfolios in the next several quarters, as loan repricing will be slow for the remaining fixed-rate loans, equivalent to about one-third of outstanding domestic loans. This will reduce net interest margin by a few basis points, although this does not affect our long-term investment thesis that larger banks can manage to keep margins steady around 1% through business diversification outside of traditional lending activities. For example, net interest income-to-recurring income has fallen to 48.2% for Mitsubishi UFJ, which is below the G-SIB average of 51.4%.
Outside of Japan, our focus remains on the pace of income expansion from higher asset yields globally, as larger banks have replaced more foreign assets at higher yields. Our top pick remains Mitsubishi UFJ Financial Group (MTU), as the group remains best positioned from an improving operating environment globally with 40% of earning assets tied to non-domestic markets.
The group is still facing challenges given lower interests rates are expected to remain for a few more years in Japan and the pace of the group's cost saving initiatives will take seven years to realize, compared with three years for its peers. However, the bank remains arguably overcapitalized with the latest common equity Tier 1 capital ratio rising to 11.76%. Assuming the Basel IV output floor, which will limit the extent to which banks can use their own models to calculate the riskiness of their lending, will not be lower than 70% for regulatory reporting purposes, the group is likely to emerge with larger-than-expected excess capital reflecting its conservative capital provisioning in the past.
Singapore Banks: We're less bullish on Oversea-Chinese Banking Corporation (O39) compared with earlier this year, after share prices of the three Singapore banks sustained their appreciation earlier in the quarter. Although their share prices have softened since, the margin of safety is not large enough for us to recommend the three banks.
Second-quarter results were fairly positive for the three banks, as economic conditions in the region were largely supportive, and we expect this to continue in the second half. While economic conditions are supportive, growth is not overly strong, and this was reflected in mixed loan growth in the second quarter.
We continue to forecast low-single-digit loan growth for the full year, while net interest margins are yet to fully benefit from the increase in the rising U.S. interest rates. While interbank rates are higher relative to the first half of last year, they have moderated slightly against the highs in the second half of last year. We maintain our view that net interest margin increase will be largely flat for the Singaporean banks with further increases in fiscal 2018.
Positively, asset quality remained steady for another quarter, although there will not be an improvement in asset quality in the near term, as oil-related loans remain pressured from the weak oil prices. All three banks' allowance covers their non-performing loans by at least one times, and they have strong capital positions.
Australian Financials Update
By David Ellis
We are comfortable with the Australian major banks' exposure to residential and commercial property markets in Australia and New Zealand. Bank balance sheets are strong, organic capital generation solid, home loan and repayment buffers are in place, and net household debt remains steady around 110%-120% levels.
Solid economic activity is supported by strong infrastructure spend, strong residential construction in major east coast cities, higher commodity export prices, increasing export volumes, record-low interest rates, good credit growth, low unemployment, and GDP growth. Although wage growth and savings levels remain low, on balance we believe the current macroeconomic backdrop remains favorable for the Australian major banks as well as the broader financial sector.
In our opinion, Australia's largest and most profitable bank, wide-moat rated Commonwealth Bank of Australia (CBA), remains in a strong financial position despite increasing regulatory and legal risk following anti-money laundering allegations raised in early August. We reduced the bank's stewardship rating to standard from exemplary in early August, and several subsequent events have driven a sharp fall in the share price.
On Sept. 8, 2017, the banking regulator, Australian Prudential Regulation Authority, or APRA, followed up its surprise Aug. 28, 2017, announcement of a prudential inquiry into Commonwealth Bank with details of panel members and inquiry terms of reference. We maintain our position the inquiry is an appropriate and welcome regulatory response, with the panel expected to issue a final report to APRA by April 30, 2018, with a progress report due Jan. 31, 2018.
Despite significant reputational damage incurred during the past six weeks, we remain focused on Commonwealth Bank's stellar performance track record and the strong likelihood of further solid future performance. The bank impressed again in August with its fiscal 2017 results, delivering a solid underlying performance with a 5% increase in profit to a record AUD 9.9 billion and a 16% ROE. The result was typical Commonwealth Bank--clean, solid, and big. All key fiscal 2017 profit and loss and balance sheet metrics reinforced our positive view.
European Financials Update
By Derya Guzel and Henry Heathfield
European Banks: Themes have changed little for European banks during the past quarter, with digital expansions, cost-cutting, and regulatory issues continuing to emerge. In keeping with general trends for banks globally, European Banks continue to invest in digitalization and slim down their physical presences around Europe.
As indicated by EU banks' restructuring plans, which aim to cut costs in the environment of lower interest rates and declining NIMs, European banks closed over 9,000 branches last year and shed 50,000 staff, according to data published by the European Banking Federation, or EBF. The total number of bank branches in the EU stood at 189,270 in 2016, a decline of 4.6% when compared with the previous year. We expect continued branch closures and gradual reduction in full-time employees until 2020, as many of the banks under our coverage are going digital and investing in fintech startups. According to the EBF report, there were 6,596 lenders across the European Union, nearly 25% of which are in Germany. We rate the German banking system as "fair" (one step above poor), as it is home to around 1,700 banks, which makes the sector heterogeneous, interconnected, and highly fragmented.
Finally, Nordea (NDA) has reached a decision to move its headquarters from Stockholm to Helsinki in the banking union area, due to the heavy regulatory burden imposed by the Swedish FSA. As a result, we believe Europe's Single Supervisory Mechanism, or SSM, has now proved itself to be a widely respected supervisor. As it stands, while we do not expect such a move from other banks in the immediate term, Denmark may have to consider joining the SSM in the near term to become more attractive for other players. We view Nordea moving its headquarters as neutral to its intrinsic value, and so we maintain our narrow moat and stable moat trend ratings for the bank. We believe lower regulatory costs will be a long-term positive for the firm's P&L.
Signs of increased competition from fintech firms versus mainstream banks have been much discussed during the quarter. Sweden-based Klarna, one of the largest fintech groups (with 60 million customers and EUR 13 billion in transactions) gained a banking license; it aims to become a Ryanair of banking across Europe. Klarna has a large market share across the Nordic countries and Germany. In the long run, we expect higher levels of collaboration between fintech companies and retail banks, as well as investment from major banks in fintech companies, as we saw with U.S. investment bank Goldman Sachs (GS). Goldman Sachs made its first investment in the British consumer lender market by investing GBP 100 million in Neyber, a fintech company providing loans that are repaid directly from customer salaries.
European Insurance: We believe the emerging theme for European Insurers is asset management. We have seen several business developments in this area over 2017. These businesses are trying to combat the headwinds from sales of index-linked products and ETFs, as well as the low rate environment.
Generali (G) unveiled European asset management plans on May 11 of this year to tackle two strategic objectives: 1. Broaden and deepen investment capabilities and product offering; 2. Accelerate growth and transform by pursuing a focused distribution strategy. This was aimed at insurance and individual clients.
Generali is essentially looking to move up the scale in terms of asset allocation margin and match real assets with its liabilities. The target is a trebling of the net result by 2020. And in terms of distribution, retail clients will be served by a central retail distribution team for bank channels, IFAs, and wealth management platforms in Europe.
Around the same time, May 2017, AXA (CS) announced plans to spin off its U.S. businesses. This includes AllianceBernstein, which manages $500 billion in assets under management, as well as the U.S. Life and Savings business. Though announced due to a change in management, we believe this was an underperforming business unit, and this IPO will essentially give the overall group greater room to operate under the differing capital regimes.
Following on from this, most recently (September 2017), AXA Investment Managers have been linked to a potential merger with Natixis. Another historically fairly poorly performing AXA asset manager, we believe this action might be taken to bolster the business unit against the rising scale within the European asset management landscape. This rising scale is, for example, resulting from the three broader asset management corporate actions: the merger between Aberdeen Asset Management and Standard Life; Amundi’s acquisition of Pioneer; and the Henderson and Janus tie-up.
Really, AXA IM are most likely also looking to deepen their capabilities. Having made a big absolute-return strategies push in September 2016, on the back of the larger European response to their rising popularity, we believe the business is looking to strengthen its capabilities in providing low volatility, competitive return funds that bring higher fees and serve as a replacement for the increasingly absent with-profit style guarantee funds. And as they aim to limit volatility, they also serve as pseudo downside protection.
Lastly, we have seen Prudential plc (PRU) throw its hat into the ring. In August 2017, the group announced a merger of its underperforming U.K. businesses, M&G Asset Management, and Prudential U.K. & Europe, with Anne Richards having been brought in in June 2016 to replace longtime M&G CEO Michael McLintock. A change to business was therefore more likely as McLintock had been a staunch defender of the business unit.
We believe this combination is predominantly motivated by the wish to bring asset management and long-term savings product asset management closer together, particularly in light of the changing product environment. But also to ensure that this is matched with progression in its distribution capabilities, as this is a fast-changing element. The combined entity will invest GBP 250 million to turn the combined unit "M&G Prudential" into an "efficient, service-led, digitally enabled business."
What it is really being targeted here is retail investment business, such as ISAs, SIPPS and any other long-term savings business Prudential can easily gain access to. This will be done, similar to AXA IM and Natixis proposal, by bringing together M&Gs active management with Prudential UK & Europe's volatility-adjusted savings and liability-driven investments business.
Overall, there is increasing self-reliance for savings, and digital service is becoming an ever more important part of the distribution landscape. The large operators are teeing themselves up in a similar way to established banks and the advent of Internet banking. Up and coming Internet banks failed because established players adapted their business models rather than allowing the new entrants to disrupt the market.
American International Group (AIG)
Star Rating: 4 Stars
Economic Moat: None
Fair Value Estimate: $76.00
Fair Value Uncertainty: Medium
5-Star Price: $53.20
When AIG announced that it would be taking a $5.6 billion reserve development charge in the fourth quarter, the market's confidence in management dimmed and the stock now trades at a significant discount to book value. Given the potential for improvement, we think the market valuation is overly skeptical and creates an opportunity, especially as the recent reinsurance deal with Berkshire Hathaway (BRK.B) largely mitigates reserve development risk going forward. We believe that new CEO Brian Duperreault's background, with his demonstrated success in building strong commercial underwriting operations, is close to ideal for AIG's current situation, and are optimistic that he will be effective in solving the company's existing issues. We think a valuation close to book value is appropriate, as our view is that AIG will improve returns to a level on par with other no-moat insurers, a fairly low bar to clear.
Capital One Financial (COF)
Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Estimate: $106.00
Fair Value Uncertainty: Medium
5-Star Price: $74.20
We believe rising charge-offs at narrow-moat Capital One have created another investment opportunity in what we regard as one of the best-managed banks we cover. While rising charge-offs have caused a sell-off in the stock, we view it as an expected normalization of credit losses and simply the result of Capital One's growth strategy. The stock currently trades below book value, which we view as too cheap.
Wells Fargo (WFC)
Star Rating: 4 Stars
Economic Moat: Wide
Fair Value Estimate: $67.00
Fair Value Uncertainty: Medium
5-Star Price: $46.90
We believe the recent controversies surrounding U.S. bank Wells Fargo have created a buying opportunity. The company is already showing some signs of stabilization. Customer branch activity has declined only slightly, and account closures did not spike significantly, indicating that customers are not departing for competitors. Average deposit balances--the key source of Wells Fargo's competitive advantage--are continuing to expand at a healthy rate. Finally, Wells Fargo has reimbursed only a few million dollars to customers as a result of fraudulent accounts. We believe this supports the assertion that the vast majority of the bank's revenue comes from legitimate sources. We believe the bank will more than recover from the issues of 2016, and we like the company's roughly 3% dividend yield.
More Market Outlooks
Stock Market Outlook: China Rebalancing Presents Winners and Losers
Credit Market Insights: A Solid Quarter for the Bond Markets
Basic Materials: Valuations Propped Up by Shaky China Fundamentals
Communication Services: Smaller Rivals Call the Shots in U.S. Wireless
Consumer Cyclical: Tepid Mall Traffic Could Constrain the All-Important Holiday Season
Consumer Defensive: Valuations More Reasonable After Third-Quarter Retreat
Healthcare: Stock Selection Key as Valuations Rise
Real Estate: Enter With Caution
Technology: Valuations Painting Overly Rosy Scenarios
Utilities: Valuations Still Running Out of Control
M&A Outlook: High Prices Impede Dealmaking in the U.S.
Private Equity Outlook: Larger Funds, Larger Deals
Venture Capital Outlook: Exits Come Into Focus as Valuations Continue to Climb
U.S. Stock Funds: Steady as She Goes
International-Stock Funds: The Beat Goes on
Bond Funds: A Period of Relative Calm
Michael Wong does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.