We are keeping our NEUTRAL sector call. Currently trading at FY20E PE of 12.3x and PBV of 0.9x, we think sector valuations appear decent. Factors such as an OPR cycle that is now closer to the bottom and Day One Modification losses that may not be as bad as initially feared are also positives. However, what keeps us from turning more constructive on the sector is the lack of visibility on asset quality. The loan moratorium and various SME lending programmes mask the true impact of the economic downturn on asset quality and hence, while banks continue to book in pre-emptive loan provisioning, it is difficult to gauge the adequacy of these provisions at this juncture. From a capital perspective, our assessment suggests that banks’ CET-1 ratios are strong enough to weather a spike in GIL to 2x FY19/FY20 levels but at 3x, there may be concerns for CIMB. Our top pick is RHB, while we also like HLBK and AMMB. CIMB and Affin are key UNDERPERFORM calls on asset quality concerns.

Banking sector lagged FBMKLCI. The banking sector (based on the main eight banking stocks) saw returns stabilising in 2Q20 (+2%), after having slipped 20% in 1Q. Notably, it was the smaller banks such as Affin (UP; TP: RM1.45) and ABMB (MP; TP: RM2.20) that were the standout performers during the quarter while the big and mid-cap banks turned in a more muted performance. Nevertheless, the banking sector continued to lag the FBMKLCI, which posted a strong rebound of 11% in 2Q after a drop of 15% in 1Q. On YTD basis, the sector is still down 18% vs. FBMKLCI: 6%. Banking stocks that outperformed the sector YTD were MAYBANK (MP; TP: RM7.85) and PBK (MP; TP: RM18.00) while key underperformers were CIMB (UP; TP: RM3.45) and AMMB (OP; TP: RM3.60).

Expect weak macro data and earnings from banks in the near term. Banks' earnings in the upcoming 2QCY20 results season will be under pressure at both top-line level as well as loan provisioning. The combination of OPR cuts and Day One modification losses will lead to a hit on margins while the continued build up in pre-emptive provisioning ahead of the expiry of the loan moratorium period will further dampen bottom-line. That said, recent guidance by some banks suggest that the impact from modification losses will not be as severe as initially expected, thanks to modification gains from concessionary rate funding. Treasury income should also be healthy in 2Q. Beyond the upcoming results, we see asset quality as the key headwind that banks will face, and visibility remains poor at this stage. Despite building up pre-emptive provisioning, the sufficiency of these provisions will only likely be clearer next year. Based on macro level data, we are concerned with respect to the level of unemployment, which is already at a multi-decade high. On a micro level, we have assessed the banks’ sectorial and customer segment exposures and we think that banks’ with a higher proportion of corporate loan mix (Affin, AMMB, CIMB, MAYBANK) may be at higher risk during the moratorium period and beyond, mainly as these are chunky loans and provisioning are lumpy. Meanwhile, HLBK (OP; TP: RM17.00) and PBK may offer shelter from the storm as a larger proportion of their loan book are currently under moratorium and asset quality for these banks are superior to peers.

Banks expected to be able to absorb a doubling of GILs. Based on banks’ guidance for a 2-2.5x rise in credit cost, we estimate sector GIL could eventually rise by 40%-65%, while assuming 2021F credit cost stays elevated at 2020F levels, an eventual doubling in sector GIL is a possibility. We have performed a scenario analysis as to the impact on banks’ CET-1 capital ratios in the event of a 2-3x increase in GIL. We have assumed that a RM1 increase in GIL: (i) will require an incremental RM1 in loan impairments, and (ii) leads to a rise of RM0.75 in RWA. We find the banks’ capital ratios to be sufficiently healthy to absorb a doubling of GIL. The current weak loan growth environment will help curb RWA expansion while the utilisation of regulatory reserves serves to further cushion the impact on capital. At a level of 3x above FY19/FY20 levels, CIMB appears more vulnerable to a capital raising exercise as we estimate its CET-1 ratio could dip below the 10% level.

Forecasts. We forecast 2020 sector net profit to fall by 23% followed by a recovery of +12% in 2021. Our estimates suggest that the banks will need to look beyond 2021 before net profit levels can recover to 2019 levels. In our models, we have assumed banks such as Maybank and CIMB resuming with their DRP programme to preserve capital. Hence, our 2020E sector EPS stands with a sharper contraction of 27% followed by a 10% YoY recovery in 2021F. NIM compression and credit cost are the key drivers of net profit trends ahead.

Maintain NEUTRAL sector call. RHB (OP, TP: RM6.00) is our top sector pick on attractive valuations and solid capital ratios to absorb higher loan allowances while maintaining a decent dividend payout. In addition, it is less impacted by Day One modification losses. We also like HLBK as a defensive, “high quality” bank with a strong digital infrastructure that is poised to benefit from a post Covid-19 environment. AMMB’s valuations appear undemanding and we think the stock could be an attractive catch-up play. Furthermore, AMMB had booked in aggressive pre emptive loan provisioning in 4QFY20 while recent guidance on Day One Modification losses seem much lower than initial estimates. Despite our MARKET PERFORM rating on PBK, we think it may offer investors a shelter until asset quality issues come to pass but longer-term growth may lag peers. We rate Affin and CIMB as UNDERPERFORM mainly due to asset quality concerns and CIMB’s weaker capital position if asset quality pans out worse than expected. Near-term key upside risk to our sector call is a liquidity fuelled rally and/or rotation into value/cyclicals. Key near-term downside risk is if an economic lockdown is required should a Covid-19 second wave emerges.

Source: Kenanga Research - 9 Jul 2020