Ahead of the Curve | Friday, 5th November 2021

European Bank earnings – shaping up to be the fifth quarter in a row of big beats
Earnings for the European banks’ third quarter 2021 have started to be released and once again we are seeing very strong performance across nearly all line items.  Net interest income is beating estimates on higher mortgage volumes, and fees continue to be much stronger than expected, driven by investment banking revenues, asset/wealth management flows, and recovering payment/transaction volumes, resulting in average net revenues 4% ahead of consensus.  With operating leverage these beats are multiplied to 11% ahead at the pre-provision profit level, and with loan losses continuing to come in nearly 40% below expectations, bottom-line profits are well over 30% ahead of consensus.  We see scope for continued beats going forward, most notably from recovering corporate loan demand, loan loss estimates that still remain too conservative, and potentially much sooner hikes from developed market central banks and the incorporation of hikes already seen in many emerging market countries to which European banks have exposure.  Moreover, despite the sector’s strong YTD performance, it has actually lagged the increase in 12-month forward EPS upgrades, meaning the sector has actually de-rated YTD, suggesting room for continued upside.

Dramatic moves in front end rates globally
We have seen a significant repricing of the front end of the curve in the past several weeks across the globe. The market has begun to price in a more frontloaded rate hike cycle than previously expected as the transitory inflation thesis looks increasingly in doubt. So far we have seen some central banks already start to hike (Poland, Korea, Brazil, and Russia, among many), while larger ones (BOE, Fed) look likely to move in the relatively near term.  In addition, other developed market central banks have signaled the end of extraordinary quantitative easing (Canada) and yield curve control (Australia) measures, resulting is similarly large yield curve repricings.  Perhaps most surprisingly, the market is even starting to factor in rate hikes at the likes of the ECB: the implied policy rate in 3 years is now -6 bps, versus -45 bps just three months ago.

Implications of these moves for banks
It is not clear at this point whether these moves are justified, but we would make the following key points as it relates to banks.

            1. Should we be concerned about the curve? There is some fear that a premature and/or overly aggressive hiking cycle will represent a policy error and snuff out growth – we see this for instance in some flattening of curves and slight cooling off of longer term inflation breakevens. This is a fair concern but we would point out that the curve most relevant for bank earnings, the 3 month-5 year spread, is at new highs as the belly of the curve has repriced most dramatically – this suggests funding costs will remain subdued while asset yields start to move higher. The long end is generally less relevant to bank earnings but can be a driver of the PE multiple – and so far long yields remain near YTD highs.

            2. Earnings impact even better than we thought? Fundamentally, most banks today are highly levered to a move up in short term rates. This is particularly true in Europe where rates have been negative for several years now, and in the US where banks are sitting on unusually high levels of cash. Banks disclose the positive sensitivity to a move in rates (for instance, Commerzbank suggests earnings will rise >100% with a 100 bps move in rates), but what is notable is that these bank disclosures could well be understating the positive impact. This is due to assumed deposit betas (ie the degree to which rate hikes are partially passed on to depositors) being too high. Most banks assume ~50% betas and the actual pass-through will likely be much lower, at least for the early part of the hiking cycle.  We saw this in the last US hiking cycle and we heard at 3Q earnings from multiple UK banks that their actual deposit betas will be lower than modeled – this is a clear positive for earnings.

            3. What’s priced in? In the US, bank estimates already bake in 3-4 hikes over the next two years (versus 4 as currently priced by the bond market) and valuations are well above historical normal – so the upside to earnings and multiples on higher rates appears relatively limited at this point. On the other hand, no banks in Europe currently have higher rates embedded in earnings estimates, and the stocks trade well below historical average – a much more attractive mix than in the US, in our view.