Investment summary

Chinese banks reported solid earnings growth with sector pre-provision operating profits (PPOP) rising 11% y/y or 4% q/q in 2Q18. Agricultural Bank of China (1288 HK) and China Merchants Bank (3968 HK) delivered stronger growth of +19% and +16% y/y, respectively. Stable and improving trends were reported in net interest margin (NIM) and asset quality. The Big-4 banks continued to stand out in terms of asset quality trend with the Big-4 banks reporting a non-performing loan (NPL) ratio of 1.52%, down 2bps q/q, but still outperforming the industry average of 1.86%, up 11bp q/q. Fee income growth surprised on the upside and rose 5% y/y in 2Q18 vs a contraction of −2% y/y in 1Q18 with bank card fees being the key driver. Most banks reported better-than-expected fee income growth.

Market volatility is likely to remain elevated, so we view H-shares of Chinese banks as defensive plays with its yield support—the sector is offering about 5.5% dividend yield. The government has reiterated that deleveraging will remain its policy focus and we believe its implementation will likely take the “stop-and-go” approach to manage the slowdown in domestic growth and the impact of a challenging trade environment. We expect Chinese banks will be range-bound between 0.7 and 0.9x PB in the medium term. Our preference stays with the large banks as they have more favourable valuation and return profile as well as less exposure to shadow banking activities. We prefer ABC (1288 HK), CCB (939 HK), and ICBC (1398 HK).

Net interest margin improved

The Big banks continued to deliver above industry average NIM trend except for Bank of China (3988 HK) at 1.9%. China Construction Bank (CCB) (939 HK) achieved the largest expansion of +17bp y/y to 2.3% among the Big-4 banks. Going into 2H18, this momentum of NIM expansion is likely to diminish as the pace of loan yield increase slows down, and as the easing environment is generally negative for the banks’ asset yields. Hence, the ability to control deposit costs will be a key driver for NIM expansion. We expect a divergent trend in NIM expansion with the large banks having a stable and flat NIM outlook, whereas the small- and mid-cap banks could still have NIM expansion as they are interbank net borrowers and will benefit from an easing environment with lower interbank rates.

Stable asset quality

The NPL ratio edged up 10bp q/q for the industry as shown in the chart below, which was partly due to the tightening on NPL reclassification to include all loans overdue more than 90 days into NPLs, thus mainly affecting the small- and mid-cap banks. The Big-4 banks continued to perform better than the industry with a reported NPL ratio of 1.5%, down 2bp q/q. On the other hand, the special mention loan (SML) ratio has continued to trend down. A diverging trend was seen with small- and mid-cap banks seeing a higher gross NPL formation sequentially, mainly owing to a more stringent NPL recognition policy so as to meet the regulatory requirement of having a minimum of 100% for the NPL to overdue loan >3m ratio. The overall NPL coverage ratio was down 13bp q/q to 179%. The Big-4 banks bucked the trend and edged up modestly as highlighted in the chart below, suggesting the Big-4 banks have better asset quality trends among industry players. Among the Big-4 banks, ABC (1288 HK) posted a positive surprise in asset quality with the biggest improvement sequentially in NPL ratio, which dropped 6bps q/q to 1.6%. Its provision level was the highest at 248%, up 10ppt q/q.

Fee income growth being a positive surprise

Fee income growth came in better than expected and grew 5% y/y in 2Q18, turning around from a decline of 2% y/y in 1Q18. The key driver for fee income growth was the bank card fees, which surged 21% y/y, offsetting the weakness in custody and wealth management fees. We expect the drag from wealth management fees to continue owing to ongoing regulatory tightening. Among the Big-4 banks, ABC (1288 HK) had the strongest growth of 19% y/y.

Positive on the large banks

We view H-shares Chinese banks as defensive play as the sector is offering about 5.5% dividend yield. We view the current valuation attractive at 0.7x forward PB ratio, which is trading close to trough valuation of 0.6x in 2016. With the government’s initiatives to fine-tune policy in support of growth, plus a stable net interest margin and improving asset quality for the sector, we expect a slim chance for the sector to trade back at trough valuation unless growth collapses and the fear of a hard-landing scenario resurfaces, which are not our base case. With the government reiterating its deleveraging policy, we believe the policy’s “stop-and-go” implementation is designed to manage a slowdown in domestic growth and the impact of a challenging trade environment. We expect Chinese banks will be range-bound between 0.7 and 0.9x PB in the medium term. Our preference stays with the large banks as they have a more favourable valuation and return profile and less exposure to shadow banking activities. We prefer ABC (1288 HK), CCB (939 HK), and ICBC (1398 HK).