Banking – Singapore - UOB Kay Hian 2017-07-04: Unwinding QE – Implications For Banks

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Singapore Banking Sector QE Impact Sector Outlook DBS GROUP HOLDINGS LTD D05.SI OVERSEA-CHINESE BANKING CORP O39.SI UNITED OVERSEAS BANK LTD U11.SI

Banking – Singapore - Unwinding QE – Implications For Banks

• The FED will commence balance sheet normalisation in a predictable manner in late-17 and has disclosed the mechanism to gradually reduce reinvestment of principal repayments for treasury and mortgage-backed securities that have matured. 
• We postulate that normalisation of the size of central banks’ balance sheets downward would lead to normalisation of valuations for banks upward. 
• Maintain OVERWEIGHT.

WHAT’S NEW

• It has been almost nine years since Lehman Brothers filed for chapter 11 bankruptcy protection on 15 Sep 08, which set off the Global Financial Crisis (GFC). 
• The Federal Reserve (FED) and, subsequently the European Central Bank (ECB), deployed unconventional ultra-easy monetary policies to combat the deflationary spiral. These unconventional monetary policies are about to be reversed.

FED – Honey I shrunk the balance sheet. 

• The size of the FED’s balance sheet has increased by 5-fold to US$4.5t, expanding from 7% to 25% of GDP after the GFC. The size of the FED’s balance sheet is correlated to inflation, although there is evidence that the relationship has weakened in recent years. 
• Many have also argued that the size of FED’s balance sheet creates a “moral hazard”, ie politicians could be tempted to utilise the FED’s balance sheet to fund their favourite fiscal projects.

By how much? 

• The size of FED’s balance sheet is determined by the public’s demand for currency and the amount of reserves financial institutions place with the central bank.
• Benjamin Bernanke, former governor of the FED, estimated the optimal size of FED’s balance sheet at US$4t, representing shrinkage of 11%. 
• There are also private sector estimates ranging from US$2.8t to US$3.3t, which is shrinkage of 27% to 38%.

Gradual normalisation with caps. 

• FED intends to commence implementation of balance sheet normalisation programme in a gradual and predictable manner in 2017 (most investors anticipate late-17). Its holdings of securities would be gradually downsized by reducing reinvestment of principal repayments to the extent they exceed a specified set of caps. 
• For treasury securities, the cap starts at US$6b/month and increases by US$6b every three months until it reaches a maximum of US$30b/month.
• For mortgages-backed securities, the cap starts at US$4b/month and increases by US$6b every three months until it reaches a maximum of US$20b/month.

Up-cycle for interest rates. 

• The tapering in reinvestment of principal repayments is being implemented concurrently as the FED normalise interest rates. The FED has raised target range for federal funds rate by 25bp to 1.00-1.25% in Jun 17. 
• The median projected path for federal funds rate is 1.4% at end-17, 2.1% at end-18 and 2.9% at end- 19, which implies one rate hike in 2H17 and three hikes each in 2018 and 2019.

ECB – Following what the FED did last summer. 

• In its latest monetary policy decision in Jun 17, the ECB maintained the monthly pace of net asset purchases at €60b until Dec 17 and beyond. It will also continue to reinvest principal repayments from maturing securities. While inflationary dynamics is muted, ECB focuses on providing support to reflationary forces as recovery is still in its infancy and there is slack in the labour market.
• ECB faces mounting pressure from the Bundesbank, who argued that bond purchases reduce the pressure on Eurozone governments to carry out economic reforms.
• Germany’s Finance Minister Wolfgang Schaeuble said recently that ultra-easy monetary policy encourages “undue risk taking, political complacency, capital misallocation and asset price bubbles”. At this moment, ECB has not caved in to the pressure.

ACTION

Mean reversion for banks’ valuations. 

• We postulate that normalisation of the size of central banks’ balance sheets downward would lead to normalisation of valuations for banks upward: 
  1. Easing of pressure on credit spreads. The past nine years of ultra-easy monetary policies have generated a super bull run for the bond markets, including lots of carry trades. Banks have to compete to offer attractive loan packages for corporate customers, who are also evaluating issuance of bonds as an alternative. The converse is true now as bond markets undergo correction over the next few years.
  2. Positive dynamics as economic recovery gathers pace. The FED observed that household spending has picked up in recent months and business fixed investments has continued to expand in the US. Similarly, economic recovery has also strengthened in the Eurozone. Purchasing managers’ index has risen to a 6-year high while unemployment rate has been declining. There are also signs of a comeback in business fixed investments as the recovery broadens.

Maintain OVERWEIGHT. 

• We anticipate a gradual re-rating for banks’ share prices.
• Banks have traded mostly below their long-term means for P/Bs over the past nine years. The normalisation of central banks’ balance sheets could energise banks’ share prices and lift their valuations towards and above their mid-cycle valuations.
• We have rolled forward our valuations to 2018.

DBS Group Holdings (BUY/S$20.65/Target: S$25.25). 

• We raised our earnings forecast for 2018 by 1.9% as we factored in NIM expansion of 5bp to 1.82%. 
• Our target price of S$25.25 is based on 1.30x 2018F P/B, which is derived from the Gordon Growth Model (ROE: 10.1%, COE: 8.0% (Beta: 1.1x) and Growth: 1.0%).

Oversea-Chinese Banking Corp (BUY/S$10.72/Target: S$13.00). 

• We raised our earnings forecast for 2018 by 0.4% as we factored in NIM expansion of 3bp to 1.66%.
• Our target price of S$13.00 is based on 1.36x 2018F P/B, which is derived from the Gordon Growth Model (ROE: 10.0%, COE: 7.75% (Beta: 1.05x) and Growth: 1.5%).

United Overseas Bank (NOT RATED/S$23.05). 

• UOB is a conservative bank, as can be seen from its lowest exposure to the oil & gas sector at 5.2% of total loans.

SECTOR CATALYSTS

• Rising interest rates and bond yields.
• Easing of pressure on asset quality from the O&G sector.
• Decent 2017F dividend yield of 2.9% for DBS and 3.4% for OCBC.

ASSUMPTION CHANGES

• We maintain our existing earnings forecast.

RISKS

• Rapid increase in the federal funds target rate (steep rate hikes) that may trigger capital outflows from countries in Southeast Asia.

Jonathan Koh CFA UOB Kay Hian | http://research.uobkayhian.com/ 2017-07-04

UOB Kay Hian SGX Stock Analyst Report BUY Maintain BUY 25.25 Up 23.300

BUY Maintain BUY 13.00 Up 11.700

NOT RATED Maintain NOT RATED 99998.000 Same 99998.000