Following the tail risks flagged out in our global financials sector rating downgrade (Global Financials – Higher growth risks ahead), the 2Y-10Y US Treasury yield curve has inverted for a second time this year reflecting increased recessionary worries by the bond markets. Our house view remains cautious (Investment strategy: Beware of bear rally, focus on selective opportunities) on global equities and recession risks are expected to remain elevated. Other than the treasury yield curve, other key indicators we continue to monitor include the US Conference board leading economic index (which has started to soften) and potential inflection points in the unemployment rate.
Given the financials sector’s macro sensitivity and our view that we are likely in the last leg of the rate trade for the sector, we reiterate our earlier advice for sector weights to be prudently managed within investors’ portfolios. Our economist expects the Fed funds rate will likely peak in early 2023 (Macroeconomics: US technical recession not real (yet)). Thereafter, market attention could shift towards the potential for a reversal in policy next year should economic growth or inflationary pressures ease more meaningfully. In terms of sector implications, this suggests a continued mixed outlook for global banks (Tussle between rate benefits and recession worries) in the coming quarters. While banks are entering the downturn with stronger balance sheets compared to past recessions and guidance remains fairly constructive helped by re-opening tailwinds, near-term share price performance will likely remain pressured as downside risks to growth have increased with aggressive rate hikes in 2H22 (Macroeconomics: Fed hikes & recession risks).
The MSCI Singapore Financials Index has lagged the broad Singapore equity market over the past months since our downgrade of the global financials sector and advice to take some profits off the table. Due to the Federal Reserve’s (Fed) determination to combat elevated inflation, our economist expects the Fed funds rates may hit 3.75-4% by early 2023 (Macroeconomics: US technical recession not real (yet)). This implies rate-sensitive Singapore banks should still see net interest income (NII) growth and net interest margins (NIM) expansion in the coming quarters, which is supportive for overall earnings and dividends.
In this report, we highlight key takeaways from Singapore banks’ recent 2Q22 earnings releases, which was a resilient set of results with aggregate sector profits growing ~9% from a year ago. Common sector trends include NII growth and NIM expansion as the rate transmission continued to flow through, which helped to mitigate weaker non-interest income as wealth management and investment banking fees were negatively impacted by weaker capital markets and more cautious investor appetite.
While the broad tone continues to be fairly constructive due to earnings upside from rates and resilient asset quality outlook (supported by current general provisions (GP) levels and recent stress test results), Singapore banks also flagged out higher macro uncertainties.
The overall guidance has turned more circumspect and watchful for spillover risks into Asia from a potential US recession next year amid more elevated geopolitical tensions and inflationary pressures globally, which is in line with our neutral stance on the sector. Looking ahead, while we expect sector provisions to normalize for Singapore banks, we do not expect a material build-up at this point due to solid GP reserves already in place which is close to ~90bps for DBS and UOB, higher than their respective provisions taken in 2020 during the Covid-19 pandemic (~57bps and 83bps of loans for DBS and UOB respectively). Should a soft-landing scenario emerge or macro worries ease into 2023, potential catalysts include improvements in sector return on equity (ROE) ratios and capital management expectations.