We are more confident on the quality of book values as we see less risk from securities portfolios today and we believe that banks have sufficient earnings to absorb credit losses. As such, we think valuations are already very undemanding at 1x Dec 09E BV. In our view, as long as the risk of book value erosion reduces incrementally, we think the sector is unlikely to retest the 0.5x PBV lows during the 1998/9 Asian Crisis. With the economy expected to trough in 2009, we expect the sector to re-rate back closer to its 1.4x PBV mean.

We upgrade UOB and OCBC to Buy (previously Neutral and Underperform). We also upgrade DBS to Neutral (previously Underperform). Our revised price objectives are S$13.95 for UOB (1.5x Dec 09E BV); S$6.50 for OCBC (1.4x Dec 09E BV); and S$9.45 for DBS (0.9x Dec 09E BV). UOB is our top pick. Tactically, we think it has the greatest potential for a rebound following its YTD underperformance (down 15% vs FSSTI which rose 5%). Fundamentally, the stock was sold down on concerns on the quality of its BV and the risk of a cash call. As these concerns are resolved, we foresee a re-rating at hand.

We have lowered our 2009E-2010E forecasts for OCBC by 14%-23% and DBS by 49% to reflect higher credit costs. Our numbers for UOB are cut by only 3%-4% as we have adjusted our forecasts earlier. Although we think there will be more consensus downgrades, we believe the market has already priced this in. The important point, in our view, is that banks will still be making money and not suffer from book value erosion.

NPLs have only just started to rise in 4Q08 and are likely to continue on an uptrend as the recession feeds through into the banking system. By our estimates, NPL rates would have to quadruple within 12 months from existing 1.5%-2% levels before banks start to bleed (assuming min. 60% loan loss coverage). We believe the chances of this materializing are slim given signs of the trade cycle stabilizing and expectations of the economy to trough in 2009.

We are starting to see signs of a bottom forming in the economy. Current leading indicators are pointing towards a sequential improvement in the economy. Seasonally adjusted NoDX figures rose 8.5% in March driven mainly by exports to China. Our economist, Silvia Liu, expects the economy to trough in 20009E after contracting by 6.5% before GDP rebounds to grow at a modest 3.2% in 2010E.