Ahead of the Curve | Friday, 1st October 2021

Bank stocks in focus as central banks turn hawkish.
Last week saw a hawkish inflection from two major central banks with the Fed chairman talking about a mid-2022 end date for their QE taper and the BOE hinting at a rate hiking cycle that could begin prior to the completion of their asset purchase programme. Both comments caught the market by surprise and led to a material upward shift in global yields. While a steeper yield curve is typically supportive of bank equity valuations, we believe the most important fundamental driver for bank earnings is the short end, and so the pull-forward of rate hike expectations should be a meaningful tailwind for the sector. In both the UK and the US, markets are now pricing in roughly two additional hikes by YE23 relative to where they were earlier this summer (and in the US, the bond market still has another ~45 bps to go to price in where the Fed has projected policy rates to be in 2024). These incremental hikes are generally not in analyst estimates and can be extremely impactful for some banks (40% EPS upside to a 100 bps move across the curve for a bank like Wells Fargo, for instance). Of course, the sensitivity is even higher in parts of Europe (Commerzbank well over 100% upside, for instance). For now that remains a free call option embedded within European bank stocks as the ECB liftoff will clearly lag other central banks. But even in Europe, the bond market is starting to sniff out an eventual normalization of monetary policy, with 3 year projected policy rates of -20 bps versus -50 bps earlier this year. With European 5yr/5yr breakeven inflation rates at the highest levels since 2014, it is not inconceivable that the pull-forward might have further to go. If so, the embedded call option will not be free for long.

Evergrande situation cools as authorities step in.
As anticipated, Chinese authorities have intervened in the Evergrande situation to facilitate a resolution of the troubled property developer.  Other stated-owned developers are being asked to take over parts of Evergrande’s portfolio – both to prevent a fire sale of properties that could create systemic risk, and to ensure that individuals who had prepaid for their properties will receive them completed.  The fate of local and foreign creditors remains somewhat uncertain, but the expectation of haircuts has become the base case scenario.  As previously mentioned, we don’t expect this to create systemic stress, as Evergrande’s total financial liabilities of $88bn is miniscule compared to total banking sector lending of $40trn.  While fears of contagion to other property developers remains elevated, the total amount of bank lending to developers of $2trn is manageable at less than 5%, particularly given a substantial proportion of this debt is backed by state-owned developers.  To be sure, we are closely monitoring for risks of a potential slowdown in domestic property investment and its impact on the Chinese and global economy.  However, we believe this potential downside risk will be mitigated by domestic policy easing, the continued reopening of the global economy, and the forthcoming expansion of capacity and associated investment spending to resolve the supply bottlenecks we are witnessing.

Adding to HSBC on overdone fears of Chinese exposure.
HSBC’s shares have been weak in recent weeks on the back of the emerging concerns in China.  The bank has disclosed a total exposure to Chinese property developers in aggregate of $6.3bn, or 0.6% of its loan book.  Nevertheless, shares have traded down to 7.3x 2023 earnings, a significant discount for one of the largest, most diversified banks that has historically traded at a 10-15% premium to the rest of the sector vs a 12% discount today.  In addition, HSBC stands poised to benefit more than most European banks from rate hikes in the US and UK.  Based on company disclosures, every 25bps rise in interest rates in the UK, US and Hong Kong (which is implicitly tied to US rates due to the currency peg) results in an approximately 7% increase in net profits.  Trading at 0.68x P/TBV, we believe there is over 50% upside as the recently elevated cost of equity normalizes, and earnings are upgraded as loan growth resumes, excess capital is returned, and ROTE accretes to 10%+.  With a total yield north of 8% today, shareholders are also well compensated in the meantime.