Brazil’s large banks have been the standout performers this year, with shares in the sector up by over 50% in dollar terms since the start of 2016. Investors in Brazilian banks have received returns far in excess of banks in other emerging market regions and elsewhere in Latin America, despite still-poor economic and credit growth and persistent questions about asset quality.
Analysts say investors need to be cautious about reading too much into recent performance. The rally to date has been driven almost entirely by a fall in the country’s risk premium following the suspension of president Dilma Rousseff and expectations that she will be fully impeached in August. This political stability had fed into a 192 basis point fall in the sovereign’s 10 year CDS between February and mid-July to 387bp (July 13); it appears to be consolidating around 400bp, and could move to a 350bp spread should Rousseff be impeached in August.
Explanation
This compression in the risk premium has led to a fall in the domestic risk-free rate (a combination of US Treasury yield, CDS and the inflation differential), with Credit Suisse calculating that it is now at 9.8% – or 6.5 percentage points below its February peak of 16.3%. This lowers assumptions about the banks’ cost of equity, which in turn supports higher target prices and fair-value multiples, and almost single-handedly explains the rally in Brazilian bank stocks this year.
There would also still appear to be some potential upside, despite the strong first-half share performance. The blended valuation of the top four Brazilian banks is 8.5 times one-year forward earnings, according to Bloomberg – below historical valuations and a 30% concession to the Bovespa’s average. Individually the picture is varied, with Santander trading at 11.7x, Itaú at 8.8x, Bradesco at 8.5x and Banco do Brasil at 5.5x.
|
Carlos Firetti, Bradesco |
Is there still further for bank shares to run? Bradesco is signalling it thinks so by announcing another tranche of its share buyback programme. Responding to written questions from Euromoney, Carlos Firetti, director of investor relations, emphasizes the programmatic nature of the buybacks, but confirms it is price sensitive: “Buybacks are generally a good use of capital, but [we] will not be aggressive on the programme… There are no specific targets… [and] we do not have any obligation in fully executing it.” Bradesco’s own board would not be alone in seeing value in Bradesco shares – Credit Suisse just changed its recommendation to overweight from neutral. Meanwhile UBS sees likely positive momentum for all Brazilian banking shares from an improvement in the fundamentals – notably it sees an end to rising provisions and NPLs in the coming quarters, and the upside to profitability and share prices that implies.
“In our view, a good time to buy the sector will likely be related to when the market thinks delinquencies have peaked, paving the way for lower provision and higher earnings,” says a report from UBS. “We think the forthcoming second-quarter 2016 results could show that provisions may have peaked.”
The report also uses historical analysis of 19 NPL cycles that suggest they typically last six or seven quarters from peak to trough. Brazil’s current cycle only started in the second quarter of 2015, and so: “In other words, if past cycle trends are repeated, the NPL ratio in Brazil may peak toward the end of 2016.”
However, this bullish assessment is contested by Credit Suisse. First, it says this cycle is atypical: “On the back of the 2014-2016 -8% GDP CAGR, the current asset cycle is unprecedented, with the credit quality deterioration potentially lasting longer than ever before.”
The Credit Suisse report also forecasts a below-consensus rate of credit growth when the economic recovery begins, given large deleveraging needs of the corporate sector that will exacerbate a projected sluggish rate of GDP growth until at least 2018.
The Swiss bank also questions whether or not the high level of provisions currently in the Brazilian banking system is the positive factor it is generally believed to be. Whereas other equity analysts point to coverage ratios (Itaú’s 90-day NPL coverage ratio is 210% for example) as a sign that fresh provisioning has likely peaked – even if NPLs continue to rise – Credit Suisse pointedly asks: “But if coverage is high, why not use them?”
Answer
|
The bank thinks it has found its answer by incorporating the renegotiated debt asset class into NPL formation. Whereas some analysts argue that the quality of the renegotiated debt portfolio is better than in the past, due to greater proactivity on the part of banks, Credit Suisse’s analysis suggests this is incorrect.
The data reported by the Brazilian banks is inconsistent but, for example, 55% to 62% of Bradesco’s renegotiated loans become delinquent again in the six to 12 months following restructuring, which emphasizes the bad-debt nature of the segment. Credit Suisse concludes that the high levels of provisions on the balance sheet, “will likely not prevent banks from having to create new provisions for troubled loans”.
Asset quality is therefore likely to remain poor, with consumer leverage remaining high and made worse by still-rising unemployment. The corporate sector is also in need of deleveraging; Brazilian companies excluding Petrobras have net debt to ebitda of 2.9x in the first quarter of 2016 – the same figure as 2014.
The conclusion seems to be that there is little certainty that the technical rally will be boosted by an improvement in the fundamentals in the coming quarters – despite still low historical valuations for Brazil’s banks.
