Ahead of the Curve | Friday, 3rd September

Bank equities and Bunds finally diverging.
Investing in European bank stocks has often felt like just another way to bet on European interest rates – as bund yields rise, stocks rise and vice versa. Clearly this has some fundamental rationale given that higher yields are typically indicative of faster growth and a rising probability of policy rate hikes. But in reality long term rates have little near term impact on bank earnings and we find that the macro too often dominates the micro in European banks. So it is interesting that there has been a clear disconnect emerging between European core yields and European bank equities since mid-July. While the bund dropped rather sharply this summer to -50 bps (before rebounding slightly), European bank stocks are near their YTD highs reached when the bund was trading at -10 bps and many commentators were starting to talk about positive rates for the first time since the pandemic began. In our view, this is a rational disconnect. European sovereign debt is in negative net supply and with a huge price insensitive buyer in the ECB, there is little economic information to glean from interest rates. Meanwhile European banks began reporting yet another strong set of earnings in July, causing investors to focus on the powerful bottom-up story that we have been discussing for several quarters now. And finally, while rates have dropped sharply, it is key to point out that breakeven inflation rates in Europe continue to trend up and are currently near 3-year highs, just as the EU Recovery Fund is finally kicking in. Breakevens, unlike rates, are not manipulated. They are telling a rather more optimistic story about medium term European growth – and European bank investors are only now starting to take note.

Global central banks commence hiking cycle, with South Korea joining the pack.
While the Fed and ECB appear to be content with their current policy rate and QE program levels, central banks elsewhere are starting to raise rates as inflation pressures mount.  To date most of these hikes have occurred in emerging market countries that typically face the problem of too much inflation, for example in Latin America (Brazil, Mexico, Chile) and Eastern Europe (Russia, Hungary, Czech Republic).  However, last week the Bank of Korea hiked rates as well – the first central bank in a more advanced economy that has for the last decade struggled with too little inflation much like the US and Europe.  While market expectations for a hike had in recent months moved forward to late 2021/early 2022, the hike did come as a surprise, with Governor Ju-yeol citing financial imbalances as a contributing factor, in addition to expected above-target inflation.  We expect the BOK to gradually continue hiking rates as it normalizes policy, and South Korean banks to benefit from higher net interest margins which have not yet been factored into consensus expectations, which we conservatively expect to add 15-25% to earnings by 2023, bringing ROTEs comfortably north of 10% despite P/TBV multiples of 0.4x today.  South Korea’s economy tends to function as a leading indicator for the global economic cycle due to its important position in global supply chains, and thus the read across here to other countries is significant – particularly in light of South Korea’s economic ties with China, which has been easing policy recently, and Delta variant concerns that have kept a lid on most global interest rates over the last few months.

Finding value in the US card space.
We recently initiated a position in Alliance Data Systems (ADS) on recent weakness in the stock. ADS, a provider of retail credit card loans and services, benefits from economic reopening, with loan growth accelerating to 7.7% in July and card payment volumes now at record highs. The company continues to show lower loss rates as well, with a 4.2% net-charge-off rate in July, and management expects to maintain NCOs below 6% through 2023. ADS also has several company-specific drivers that, in our view, should push the stock higher. The company is spinning off its Canadian loyalty rewards business in Q4 of this year. The transaction should push the parent company’s tangible common equity ratio into the high single digits, which would open the door for share repurchases. The spin will also create an independent rewards business that has a strong market position with Canadian retailers and generates consistent free cash flow. To enhance its retail credit offerings, ADS also acquired Bread, a Buy Now Pay Later technology platform. Bread is being deployed as an additional financing option for ADS’s existing retail partners, and it has built partnerships with Fiserv and RBC as both a lender and a third-party origination service. ADS expects to have loans receivable of at least $1B from the Bread platform by 2023. While most of the loan growth acceleration story appears to be built into the current share price, the spinoff value creation, share repurchase possibility, and incremental earnings potential from Bread are not. ADS trades at a discount to its credit card peers, with a Price/Consensus 2022 EPS of 7x versus an average of 10x for COF, SYF, and DFS and a P/23 EPS of 6x versus 9x for peers. Moreover, we expect both 2022 and 2023 EPS numbers for ADS to exceed consensus estimates. In the medium term, an acquisiton of ADS by a deposit-rich (and asset-starved) bank would seem highly plausible, especially with the new management and board at ADS highly focused on shareholder value.