Ahead of the Curve | Friday, 17th September

COVID-related inflation pressures subside, but stickier inflation measures continue to rise
Inflation continues to dominate the market’s attention. There are clear crosscurrents in the “sticky vs transitory” debate, which in our view has yet to be settled. Several COVID impacted sectors like used cars, lodging, and airlines have started to come off the boil, dragging down overall core inflation after providing strong contributions earlier this summer (collectively, these three accounted for just under 50% of the total 0.64% average monthly inflation from March to July). However, this was always likely to happen as price gains here were unsustainable. What is more interesting is the fact that “stickier” inflation drivers such as cost of shelter are starting to rise – and leading indicators (home price appreciation, multifamily rent growth) suggest this could be about to surge in the next 12 months. In our view, the Fed will have much more difficulty explaining away a core inflation number that is rising because of housing than dismissing the temporary effects of one-offs like used car pricing spikes. In fact, we think the market will shift its focus to core measures of inflation that strip out the most volatile items (up or down). This is exactly what the Cleveland Fed trimmed-mean CPI index does – and it has surged from ~2% pre-COVID to well over 3% today, the highest level in nearly 15 years. While the Fed and ECB remain relatively dovish and continue to tamp down the short end of the curve, pressure will build at the long end. A steeper curve and a reflationary backdrop are powerful tailwinds for financials and important drivers of P/E multiples for banks and life insurers in particular.

Sidestepping turmoil in Chinese financial markets
As investors in the global financial sector, we have been closely following the recent developments in China and their potential effect on banks, insurers, and property developers both in China and globally. What began as a regulatory crackdown on the Ant Financial IPO last November has since widened in scope to cover more and more segments of the Chinese economy, from technology to commodities to transportation to food & beverage to education to entertainment & leisure to real estate. It is this last sector that the market has been fixated on recently in light of the well-documented financial troubles at property developer Evergrande. Valuation multiples for Chinese financials are at all-time lows on fears of an Evergrande restructuring creating a systemic financial crisis. While we acknowledge the rise in Chinese risk premiums due to the increasing regulatory and macroeconomic uncertainty, we believe fears of a “Chinese Lehman moment” are overdone. The crackdown on the property market has been years in the making, with Xi Jinping declaring that “housing is for living in, not speculation” in 2017. As perhaps the epitome of the sector’s greatest excesses, Evergrande has been disproportionately hit in recent months by home sales pricing caps and developer leverage limits. While certain Evergrande creditors will certainly be haircut, most of these claims will end up tracing back to the Chinese government itself, via state-owned banks, insurers, or asset managers. However, as a proportion of their giant balance sheets Evergrande’s claims are nearly insignificant – the balance sheets of the big 4 state-owned banks alone are $20 trillion vs $271bn of total operating liabilities and debt at Evergrande (less than 2%). As has been the case in other restructurings over the past couple years, we believe authorities will ultimately facilitate an orderly restructuring to prevent knock-on effects to other sectors of the economy. Should abnormally high-risk premiums persist once these issues are clearly in the rearview mirror, we believe very compelling risk/reward opportunities could emerge in the future.

Idiosyncratic investment in post-merger US bank
While valuations are not compelling for most US regional banks, New York Community Bank (NYCB) is an exception. In April, NYCB announced it was acquiring Flagstar Bank (FBC) in an all-stock deal. The merger creates growth opportunities for Flagstar’s core businesses in commercial lending, warehouse lending, and mortgage origination. Commercial and warehouse lines have hit capital limits at FBC standalone, but the increased capital base from NYCB should provide new growth opportunities for those areas. In mortgage, the street has questioned whether FBC can maintain its gain-on-sale revenues over the next two years after the spike in mortgage originations in 2020 and 2021. However, a mix shift towards higher-margin retail originations, a resilient mortgage market, and increasing market share should allow FBC to earn gain-on-sale revenue well above consensus levels. NYCB can also benefit from lowering its historically high cost of funding. The combined company has a funding cost of 0.62% versus 0.31% average for peers. The larger bank can get a net interest margin boost from rolling CDs and wholesale funding into lower-cost deposits from the FBC side. With its robust capital position and greater earnings power, NYCB can return up to 25% of current pro-forma market cap to shareholders through dividends and buybacks over the next two years. Despite these drivers, consensus earnings estimates and a current share price in the mid-$12s incorporate no optimism about the bank’s prospects. We project 2023 earnings per share of $1.73 compared to a consensus estimate of $1.57. In a bullish scenario, NYCB can earn $2.20 per share in 2023 with proper execution on the new platform. NYCB is also cheap relative to peers, with a 2023 forward P/E of 7x versus 12x for peers and a 5.5% dividend yield versus a 3% yield for peers. In our base case, we see ~40% total return in the next two years from this investment.