Key takeaways
· 2Q17 revenues are unlikely to impress...but investment cases depend more on cost stories.
· CS remains our top pick in the EU IB space, while we remain Underperform on Deutsche Bank and Barclays.
· Potential US regulation changes could cause significant loss of competitiveness for EU IBs.
Credit Suisse is our top EU IB pick
JPM and Citi kick off the global IB reporting on Friday 14th July, while the Europeans start with DBK on the 27th July before a very busy day on the 28th when UBS, CS, BARC (and BNPP and BBVA) all report the same day. CS is our top pick in the European IB space where we still see >20% total returns. Our investment case requires the bank to continue delivering a clear route to achieve its business targets, in particular in costs where the company is adamant it will achieve <CHF17bn in costs by 2018: this would imply significant EPS upgrades. We remain Underperform on DBK and BARC.
What to watch 1: Europe versus US
Brexit volatility in June 2016 saw the Europeans lose out and US banks prosper, particularly in FICC (US FICC revenues were +23% yoy, EU -11%). This trend carried on for the rest of 2016. Comps are in theory easier for the Europeans than the US and 2Q17 should help determine how much of the market share losses are real and not just quarterly noise. BARC and DBK both have strategies to reinvigorate their IBs, but regardlessof 2Q, we believe the market should be more focused on the potentially divergent directions of regulation between the US and Europe which could cause meaningful headwinds in the medium term for the EU IBs.
What to watch 2: cost plan delivery vital
The EU IBs all have plans to cut costs even while they target better revenues. Given the regulatory cost inflation since the crisis, the market has been understandably skeptical on progress. Nevertheless, the banks see cost reductions from various legal entity programs (in particular forming the IHCs in the US) and reducing consultant/contractor headcounts (CS has the highest cost here and therefore could have the greatest capacity to make savings).
What to watch 3: NII may not match the recent excitement
Despite the excitement around central bank commentary and rising long bond yields, short term rates in Europe and Switzerland have not moved(not are they expected to move in the near term) and this means it is more likely that we see lower NII revenues, rather than higher. The erosion of NII as rates stand still is a particular headwind for DBK, in our view: 1Q17 NII fell EUR0.5bn qoq and undermine the more attractive scenario where +100bp in EUR and USD could add EUR1.4bn in extra NII.
2Q17 overview
FX is unhelpful qoq for the Swiss and balances some helpful market level moves (e.g. SPX up +3% in 2Q17…but down -2% in CHF terms). In the world of the IBs, debt issuance -11% yoy (high yield up +2%, IG -6%, MBS -26%), with ECM +12%. Trading volumes were +3% higher in fixed income, and generally stronger in equities (US cash -6%, EU cash +5%, US futures +9%, EU futures +19%). See the Capital Markets Monitor for more. Our forecasts show total EU IB revenues down -4% yoy (o/w equities -9% skewed by Asia and scope changes at CS, FICC -3% and fees -5%).
Executive summary
2Q17 reporting season starts this week
Global IB reporting kicks off on Friday with both JP Morgan and Citi. European IB reporting is bunched together the week after on Thursday 27thJuly (DBK) and 28th July (CS, UBS, BARC). Intra-quarter commentary from the US peer group suggested weaker FICC but better equities with some improvement in June versus April/May. For the readacross to Europe, it is important to note that prior year trends were very different with FICC -11% in Europe versus +23% for the US banks. We forecast IB revenues -4% with equities -9% (CS sees a bigger decline thanks to tougherAsia comps and scope changes in Global Markets), FICC -3% and IB fees -5%.
Comps about to get very tough for most banks
2Q16 saw Brexit and the start of a trend of political uncertainty, market volatility that boosted IB revenues for 2Q-4Q16. This contrasts somewhat with the more recent market activity which has in general been slower. This means that IB earnings could face several quarters of tough comps(e.g. 3Q16 FICC revenues were up +6% qoq last year, versus a normal c.-15% decline).
Wealth: no big moves in 2Q
Regularisation in WM remains a drag on inflows, but we see these effects reducing into 2018 for the larger Swiss which we believe have been more proactive. In terms of activity, we are not expecting a big bounce back in trading activity. Weaker dynamics of EUR and CHF business is partly offset by the positive effects of higher USD rates. We still see a continued or even accelerating trend towards ETFs which will remain a drag on gross margins (see charts below from The ETF-ization of the S&P 500, Part I). However, cost control has generally been positively surprising and we see huge operating leverage in these businesses. We see stable or improving net margins.
Technology spending still strong - not a driver of savings yet
Technology projects and regulatory projects are still one and the same thing. MiFID2, FRTB (Fundamental review of the trading book) and the lesser known GDPR (Global Data Protection Regulation) are all large IT projects for the IBs. Capitalised spending increased again in 2016 and implies more technology cost in the P&L again in 2017. We do not see technology as a valid route with which to cut costs just yet.
Bigger picture concerns
US competitive advantage may widen with regulation changes
We believe the sheer magnitude of the US peer group's shareholder distributions ought to send a warning signal to the European IBs that are trying to compete head-on with the US peers. The buybacks over the next 12m alone are more than the market cap of UBS. The dividends are more than the market cap of DBK.
More worryingly, the relative strength of the US peers could widen if the US Treasury's plans for reducing the regulatory burden on US banks becomes reality.
The competitive position of the European banks relative to the US therefore still looks weak in our view, despite recent capital raisings at CS and DBK and despite more aggressive language and strategy with relation to investment banking businesses, especially from DBK and Barclays.
Rates going nowhere in Europe
Market interpretations of recent speeches from the BoE and the ECB have introduced a little more volatility in European rates and FX markets. Volatility indicators have ticked up slightly in late June, but from very low bases.
In the ECB's case in particular, we still do not see a rise in the ECB deposit rate until December 2018, even as QE is tapered. Market implied rates show the ECB deposit rate around 0% by the end of 2019 or early 2020. Analyses of "100bp rate rises" for Eurozone banks are therefore just theoretical at this stage.
More worryingly, we see flat rates starting to show more NII pressure for banks in the Eurozone, and within the space this affects DBK the most (1Q17 NII fell EUR0.5bn qoq or EUR0.9bn yoy already). For a broader EU context see Stretched.
Market expectations for the overnight rate in 3 years' time have moved more, but still implies that ECB rates will barely be above 0% even by mid-2020.
"Higher rates" is therefore still very much a long-dated catalyst for bank earnings.
CS top pick in Europe
While we are cautious on EU IBs as a group given the potential for continued competitive disadvantages through differing regulatory regimes in Europe and the US, we are more constructive on CS.
CS has the "right" level of capital in our view, but no excess. Nevertheless, this is the first time we have thought that either UBS or CS has had enough capital. (UBS remains on course to reach the same levels as CS relative to leverage by 2019, partly because of higher dividend commitments).
We believe the roadmap towards better profitability at CS is more plausible than the roadmap laid out by DBK. CS needs to cut costs in the IB units (further reductions to the 23,000-strong army of outsourced or consultant headcount will be able to fix a lot of this) and see the recent hires in IWM and APAC start to deliver better inflows and move beyond breakeven. Lower litigation charges and an accelerated cut in the non-core unit shouldalso help boost reported earnings.
Better IB revenue outlook: strong 1H17
We are fairly cautious on the IB revenue outlook for 2Q17 given lower primary issuance and lower volatility at the beginning of the quarter. As a reminder, 2Q16 was a good quarter for many of the global peer group but CS and DBK in particular struggled (e.g. US bank FICC revenues were up +23% yoy in 2Q16…but were down -11% for the EU names).
2Q17: total IB revenues down -4% yoy
Our forecasts show revenues down -4% from 2Q16 levels in USD-terms, with a range of +2% at UBS (helped by equities strength) to -10% atCredit Suisse (tougher comps in equities from scope changes).
Total fee-based revenues BofAMLe -4% vs 2Q16
We see fees -5% yoy from a fairly strong prior year period. Global industry data (Dealogic) suggests a strong quarter for ECM (+20% yoy), but tougher for DCM (-9%), loans (-8%) and M&A (-5%).
Equities revenues: BofAMLe -9% vs 2Q16
We forecast Equities revenues down -9% yoy, a more negative trend than US peers. We forecast CS to be weakest, reflecting: 1) difficult comps for the Asian equities business and 2) the absence of the systematic trading business which has now moved to the asset management division (this unit generated CHF79mn revenues in 2Q16). Deutsche Bank also has tough comps given the rebuild taking place in the prime brokerage business.On the other hand, we believe UBS should be able to lead the pack after some large deals in the quarter.
Concerns around incoming MiFID 2 regulation and how this may affect the more traditional parts of the equities market continue, although Prime and derivative revenues now dominate the equities fee pool.
FICC revenues: BofAMLe -3% vs 2Q16
We forecast FICC revenues down only -3% in USD terms, with Barclays helping balance some weakness elsewhere. Credit Suisse's global numbers here also suffer from tougher comps in Asia again. However, given the less favourable trends the Europeans showed versus their US peers in 2Q16, then the EU names could outperform the US peer group.
Low volatility will have mainly affected macro products, although credit issuance was also generally weaker which tends to correlate well with secondary revenues. US debt issuance was weaker than the trends we see in Europe and Asia.