Ahead of the Curve | Thursday, 3rd February 2022

The Fed gets hawkish – Implications for banks
Last week’s FOMC meeting showcased an increasingly hawkish Fed, underpinned during the press conference by Chair Powell’s refusal to rule out a hike at every subsequent meeting this year. Equity markets took this poorly, most notably the more speculative growth segments. We continue to believe that bank stocks provide a good hedge against rising interest rates. The primary risk we see from an overly hawkish Fed is that tightening will result in slowing economic growth and a flattening yield curve. This environment could put pressure on broader credit and equity markets. However, it is notable that this cycle bears strong resemblance to that of 1999-2000, when the Fed was tightening, tech/growth stocks were faltering, curves were flattening and growth was high but slowing. In this backdrop, banks were very strong performers on both an absolute and relative basis, with US banks +33%, European banks +15% in the 18 months following the peak of the tech boom, a period during which the Nasdaq was down 64%. We think banks are well positioned to continue outperforming in this cycle, with hawkish central banks a problem for many sectors but a tailwind for top line growth at banks.

US bank earnings highlight interest rate sensitivity, cost challenges
US banks recently wrapped up fourth quarter earnings reporting. The stocks performed extremely well going into earnings, up more than 9% in the first week of the year against a 2% decline for the S&P 500 over the same period, as the 10-Year yield rose 25 basis points and a faster hiking cycle from the Fed was priced in. Once earnings hit, sentiment weakened. While banks guided higher on loan growth (which is already +10% versus a quarter ago) and net interest margins, concerns about the negative impact of higher expenses and lower fee revenues dominated investor attention. JPM led large banks in providing surprisingly high expense guidance for 2022, and capital markets and mortgage banking revenues clearly look to be normalizing from their early 2021 peaks. Sell-side analysts revised 2022 operating expenses estimates up by an average of 2% for the industry, with net -1% revision in pre-provision net revenues. All in, not a meaningful change to forward estimates but the pre-earnings euphoria has started to subside and we continue to look across the space for names that are cheap relative to earnings power and interest rate sensitivity.

UBS delivers another strong quarter, along with an impressive new business plan
UBS reported 4Q21 earnings this week, with profits coming in 25% ahead of expectations driven by beats on both revenues and costs, with beats within each operating segment as well. The investment bank continues to deliver strong revenues, while also maintain cost discipline which was well received after some cost concerns had arisen in the US. Perhaps most notably, UBS delivered well above consensus expectations on capital return – declaring a dividend of $0.50 vs expectations of $0.39, and a buyback for 2022 of $5.0bn vs expectations of $3.2bn. Put together, this implies a 10% total yield for UBS even after the 8% rally post the results. In addition, a new business plan through 2024 was presented, highlighting 10-15% annual growth in profits within the Global Wealth Management segment (vs consensus of 5%), and a ROTE target of 13-16% vs consensus of 13%, providing fuel for 10%+ earnings upgrades to estimates of long-term earnings power. We believe these targets are reasonable, particularly in light of UBS’ announced gross cost savings initiatives which will help it offset underlying cost inflation that companies globally are now confronted with, enabling operating leverage to deliver the higher targeted ROTE. Trading at 1.26x tangible book value after the post-earnings rally, UBS is one example of the value that is available in European banks today.