Latin America: UBS spies inflection point for EM banks’ valuations

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By:
Rob Dwyer
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Cost of equity (COE) dips under return on equity (ROE) as outperformance forecast; long decline in ROE since 2007 seen to have ‘bottomed-out’.

Emerging market (EM) banks could be on the verge of outperformance due to a structural improvement in both COE and the return on that equity, according to new research from UBS.

Recent falls in COE – and signs that a cyclical decline in ROE bottomed out in December 2016 – has led to the average COE being lower than the return for the first time since August 2015.

Philip-Finch_160x186

Philip Finch, UBS

As Philip Finch, the report’s leading banking strategist, points out, when combined those two inflection points imply that EM banks should trade above book value and the sector currently trades at 0.9-times price to book value.

Also, in the past, falling COE tends to lead to an expansion in banks’ valuation multiples.

“We think the importance of COE in determining the fair value is especially true for banks in LatAm where greater macro volatility can quickly change the risk-free rates and risk premium,” writes Finch.

Using UBS’s proprietary capital asset pricing model, the implied COE for EM banks is now 12.3%, down from 14.2% in March 2016.

A regional analysis shows that during the past year Asia’s banks enjoyed the biggest fall in COE, falling 260 basis points to 12.1% while Latin American banks’ COE fell 110bp to 13.1%. Banks in EMEA saw their COE rise 100bp to 12.3%.

EM banks implied ROE/COE
EM_banks_implied_RoE-600
Source: UBS

According to Finch: “The lower COE for LatAm banks reflect in part [an] improved political outlook. It can also be attributed to expectations of lower policy rates/inflation that in turn have brought down local 10-year bond yields.

“Lower COE also coincided with improved risk appetite towards the region as reflected by stronger currencies and in recent weeks also inflows of capital into the region.”

These macro-factors should continue to drive lower COE. In the largest banking market, Brazil, analysts have been revising down their expectations for the base rate to 9.0% (from 12.25%).

BNP Paribas released a report on Monday that revised its guidance for Selic at 8% “or lower” by the end of 2017 driven by 100bp cuts starting at the next meeting of the central bank’s monetary policy committee on April 12.

BNP argues that rapidly falling inflation means that real rates are rising and the bank’s current pace of 75bp cuts per meeting isn’t keeping pace with the rate of decline. With inflation expected to hit 4% by the end of the year, there should be plenty of room to cut today’s policy rate of 12.25% before they hit the average neutral real rate in recent years of around 5%.

UBS says Brazilian banks have the highest implied COE in the region, at 14.0%, with Peruvian banks at 11.8% (down from 13.4% a year ago), Argentina at 11.5% from 12.7% and Chile at 8.8% from 11.1%.

Meanwhile, COE for Colombian banks has nudged up to 11.7% from 11.3% and Mexican banks have seen the spike in political risk and interest-rate expectations lead to an increase of their COE to 11.3% from 10.0% one year earlier.

Benefits

The benefits of the falling COE are likely to be enhanced by improving ROEs in the sector. While the one-year implied forward ROE in Latin America fell by 0.4%, there are signs that the cyclical decline in EM ROEs, which began since the previous peak in 2007, bottomed out in December 2016.

“The bottoming out of ROE after five years of continuous decline indicates that the sector could be approaching a new earnings cycle while the crossing of EM banks’ implied ROE [over] their implied COE suggests that EM banks’ valuation multiples could rise further,” argues Finch.

Since the start of 2017, LatAm banks’ performance is up 13% in dollars, or up 1% in local currency. This return highlights the crucial element of FX in the trade – even if investors are convinced by UBS’s arguments on the underlying attraction on COE and ROE trends, if EM FX moves against the dollar the returns for international investors could be a negative one.

However, Credit Suisse is just one of the large investment banks that is advising clients that EM currencies are cheap and the bank expects the recent strong performance to continue.

Credit Suisse argues that the falling EM/DM inflation differential is consistent with nominal EM FX strength and the improving EM basic balance-of-payments funding gap – which is a 1.1% surplus – is a strong directional signal for EM currencies.

While Credit Suisse’s global equity analyst Alexander Redman acknowledges the upside risk to the US dollar, he argues the currency’s bull run is already in the late phase.

“Moreover, we would argue that the market has already adjusted to factor in the US election results in emerging markets FX – the blend of significantly looser fiscal policy espoused by [then] president-elect Trump in combination with our forecast for tighter Federal Reserve policy is a textbook scenario for US currency strength – typically an anathema to emerging equity investing.”