North America Strategy June 2020 Charlie Reinhard Head – North America Equity Sector Quick Comment: US Bank Stress Tests Investment Strategy We believe the annual bank stress test results released on June 25 confirm the strong balance sheets of US +1-212- 559-6251 banks, and the broader Financials sector, which offer catch-up potential, in our view (Figures 1-2). [email protected] In its official statement, the Fed highlighted that “the banking system has been a source of strength during this Steven Wieting crisis and the results of our sensitivity analyses show that our banks can remain strong in the face of even the Global Chief Investment harshest shocks." Nonetheless, out of an abundance of caution given the current economic uncertainty, the Fed Strategist +1-212- 559-0499 suspended bank buybacks and capped dividends through Q3, which was in line with most analysts’ expectations. [email protected] Bank shares and the broader Financials sector have been under pressure heading into the release of the annual stress test results due to (i) net interest margin compression in a period of low interest rates, (ii) economic Joe Fiorica, CFA Head – Equity Strategy uncertainty due to the COVID pandemic that could lead to charge-offs and loan loss provisioning, (iii) a +1-212- 559-3473 suspension of buybacks at the eight biggest banks, and (iv) dividend uncertainty in front of the stress test. As a [email protected] result, banks and Financials more broadly have lagged the market YTD (Figure 3). We believe the results and the Fed’s intent to keep the banking system well capitalized indicate that bank lending will indeed be an important part of the equation to help finance the recovery underway (Figure 4). Dodd- Frank requires large banks to run their own tests using the Fed’s severely adverse scenario assumptions and make the results public (DFAST). This year’s assumptions include a 10% unemployment rate, an 8.5% decline in GDP, a 3-month T-bill rate near zero and a 10-year Treasury yield of 0.75%. Next, the Fed tests the banks’ capital plans (due by April 6) to assure they have enough capital after buybacks and dividends to lend under these adverse scenarios (CCAR). This year an extra COVID sensitivity analysis was added due to an actual outlook worse than the hypothetical one set back in February. The Fed’s COVID analysis reflected industry level findings. In a V-shaped recovery with COVID, aggregate industry capital dropped 2.5% versus 2.1% in the severely adverse scenario described above. In a U-shaped recovery, capital dropped 3.9% and in a W-shaped recovery with a 2nd wave capital dropped 4.3%. Banks will wait until June 29 to announce any changes to their capital payout plans from the stress tests. Importantly, the Fed will for the first time ever require banks to re-submit their capital plans again later in the year and this means continued uncertainty, which the market may view somewhat negatively. Separately, on June 25 US regulators said they would ease restrictions from the Volcker Rule, allowing banks more flexibility in making investments into venture capital and avoiding the setting aside of cash for derivatives trades between different affiliates of the same firm. After June 29, we suspect investors will focus on the 2Q earnings season which for banks starts in mid-July. Once investors sense the banks are generally on top of loss provisioning for 2H20, they could focus more intently on the mortgage, credit line and PPP-related loan growth underway. Financials historically perform well when the economy recovers in the year following Institute of Supply Management (ISM) index bottoms. Comment: The Fed is trying to set a careful balance focusing attention on the capital strength of US banks heading into the crisis, while supporting the economy in an equitable way. Allowing banks to conditionally pay current dividends without growing them is the compromise. While there are large uncertainties, many aspects of the stress test are implausibly harsh, as they exclude the government’s own macroeconomic support measures. Away from all the criticism, the CCAR results estimating the financial performance of the banks through these “extremely adverse” scenarios should raise confidence in the US financial system and many of the banks themselves. Easing Volcker rules on capital is yet another counter-cyclical macro-policy measure that will support both bank profits and lending. INVESTMENT PRODUCTS: NOT FDIC INSURED • NOT CDIC INSURED • NOT GOVERNMENT INSURED • NO BANK GUARANTEE • MAY LOSE VALUE Figure 1 – Banks: Tier 1 Capital and Price-to-Book Ratio Figure 2 – Price to Book vs. ROE Sector Profile Source: Citi Private Bank (OCIS) and Factset as of June 25, 2020 Source: Citi Private Bank (OCIS) and Factset as of June 25, 2020 Figure 3 – Sector YTD Returns Figure 4 – Bank Willingness to Lend YTD Sector Return (%) Info Tech 12.4 Consumer Disc. 6.2 Comms Services 0.3 Health Care -3.2 Consumer Stap. -6.9 Materials -9.9 Real Estate -10.9 Utilities -11.2 Industrials -17.3 Financials -24.2 Energy -36.6 S&P 500 -4.7 Source: Citi Private Bank (OCIS) and Factset as of June 25, 2020 Source: Citi Private Bank (OCIS) as of June 25, 2020 Figure 5 – Largest US Financials Stocks by Segment Market Cap Name ($Bn) Diversified Financials Berkshire Hathaway Inc 431.50 BlackRock Inc 82.62 American Express Co 76.86 Banks JPMorgan Chase & Co 288.43 Bank of America Corp 206.57 Wells Fargo & Co 107.09 Insurance Chubb Ltd 56.95 Marsh & McLennan Cos Inc 53.03 Progressive Corp/The 45.25 Source: Citi Private Bank (OCIS) and Factset as of June 25, 2020 Note: For illustrative purposes only. This should not be construed as an offer of, or recommendation of companies discussed. North America Strategy June 2020 2 Asset Allocation Definitions Asset classes Benchmarked against Global equities MSCI All Country World Index, which represents 48 developed and emerging equity markets. Index components are weighted by market capitalization. Global bonds Barclays Capital Multiverse (Hedged) Index, which contains the government -related portion of the Multiverse Index, and accounts for approximately 14% of the larger index. Hedge funds HFRX Global Hedge Fund Index, which is designed to be representative of the overall composition of the hedge fund universe. It comprises all eligible hedge fund strategies; including but not limited to convertible arbitrage, distressed securities, equity hedge, equity market neutral, event driven, macro, merger arbitrage and relative value arbitrage. The strategies are asset-weighted based on the distribution of assets in the hedge fund industry. Commodities Dow Jones-UBS Commodity Index, which is composed of futures contracts on physical commodities traded on US exchanges, with the exception of aluminum, nickel and zinc, which trade on the London Metal Exchange (LME). The major commodity sectors are represented including energy, petroleum, precious metals, industrial metals, grains, livestock, softs, agriculture and ex-energy. The Thomson Reuters / Core Commodity Index is designed to provide timely and accurate representation of a long-only, broadly diversified investment in commodities through a transparent and disciplined calculation methodology. Cash Three-month LIBOR, which is the interest rates that banks charge each other in the international inter-bank market for three-month loans (usually denominated in Eurodollars). Equities Developed market MSCI World Large Cap Index, which is free-float adjusted and weighted by market capitalization. The index is large cap designed to measure the equity market performance of the large cap stocks in 23 developed markets. Large cap is defined as stocks representing roughly 70% of each market’s capitalization. US Standard & Poor’s 500 Index, which is a capitalization-weighted index that includes a representative sample of 500 leading companies in leading industries of the US economy. Although the S&P 500 focuses on the large cap segment of the market, with over 80% coverage of US equities, it is also an ideal proxy for the total market. Europe ex UK MSCI Europe ex UK Large Cap Index, which is free-float adjusted and weighted by market capitalization. The index is designed to measure large cap stock performance in each of Europe’s developed markets, except for the UK. UK MSCI UK Large Cap Index, which is free-float adjusted and weighted by market capitalization. The index is designed to measure large cap stock performance in the UK. Japan MSCI Japan Large Cap Index, which is free-float adjusted and weighted by market capitalization. The index is designed to measure large cap stock performance in Japan. Asia Pacific MSCI Asia Pacific ex Japan Large Cap Index, which is free-float adjusted and weighted by market capitalization. ex Japan The index is designed to measure the performance of large cap stocks in Australia, Hong Kong, New Zealand and Singapore. Developed market MSCI World Small Cap Index, which is a capitalization-weighted index that measures small cap stock performance small and mid-cap in 23 developed equity markets. (SMID) Emerging market MSCI Emerging Markets Index, which is free-float adjusted and weighted by market capitalization. The index is designed to measure equity market performance of 24 emerging markets. Bonds Developed sovereign Citi World Government Bond Index (WGBI), which consists of the major global investment grade government bond markets and is composed of sovereign debt, denominated in the domestic currency. To join the WGBI, the market must satisfy size, credit and barriers-to-entry requirements. In order to ensure that the WGBI remains an investment grade benchmark, a minimum credit quality of BBB–/Baa3 by either S&P or Moody's is imposed. The index is rebalanced monthly.