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The year started well for foreign banks, as evident from the impressive January-March quarter financial performance by the mega players that have reported so far. Profits were primarily driven by strong capital market results as global economic data held up well. Stability in the financial markets and optimism over global economic growth led to increased investor appetite for trading activity as well.

 

With the International Monetary Fund (IMF) raising its global economic growth outlook last month and buoyancy in the U.S. and emerging markets, foreign banks’ prospects for the upcoming quarters are even better.

 

A measurable progress on overcoming the setback that most of the major economies were witnessing for quite some time is making investors increasingly optimistic. This, coupled with the expectation of improving profit margins with some economies nearing the turning points of their monetary policy cycles and increasing demand from relatively less levered consumers and businesses,has helped foreign bank stocks leave the broader market behind this year.

 

This is clearly evident from the Zacks categorized Banks-Foreign industry’s year-to-date rally of 9.8% versus the 7.1% gain of the S&P 500.

       

Before we delve a little deeper into the industry’s current backdrop and assess its prospects, let’s take a look at whether it’s worth paying more premium for the stocks in the industry.

 

Are Foreign Bank Stocks Still Undervalued?

 

While the industry has outperformed the broader market so far this year, there is still a value-oriented path ahead. Looking at the industry’s price-to-book ratio, which is the best multiple for valuing banks because of large variations in their earnings results from one quarter to the next, investors might still want to pay more.

 

The industry currently has a trailing 12 month P/B ratio of 1.71 – close to the highest level of 1.73 since the beginning of the year. When compared with the median level of 1.42 over that period, any further upside potential looks unlikely.

 

However, the space actually compares pretty favorably with the market at large, as the trailing 12-month P/B for the S&P 500 is at 3.56 and the median level is 3.52.

 

As finance stocks typically have a lower P/B ratio, comparing foreign banks with the S&P 500 may not make sense to many value investors. But comparing the group’s P/B ratio with that of its border sector ensures that the group is undervalued. Zacks categorized Finance sector’s trailing 12-month P/B ratio of 2.47 and the median level of 2.32 over the same period are way above the Banks-Foreign industry’s respective ratios.  

Overall, while the valuation from a P/B perspective looks stretched when compared with the industry’s own range in the time period, its lower-than-market and lower-than-sector positioning calls for a decent upside in the quarters ahead.

The group’s Zacks Industry Rank confirms this view. This 65-company industry carries a Zacks Industry Rank of #86, which places it at the top 34% of over 250 Zacks classified industries. Our back-testing shows that the top 50% of the Zacks ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.

Expected Economic Growth to Bolster Profitability

The IMF sounded optimistic about global economic growth in 2017 and 2018. Last month, the fund predicted that the economy will grow 3.5% in 2017 and 3.6% in 2018 versus 3.1% in 2016. This pickup is expected to stem from a rebound in investment, manufacturing and trade across economies.

The IMF expects continued policy support in China, coupled with fiscal expansion and deregulation in the U.S., to keep financial markets buoyant. The advanced economies, in particular, are likely to witness decent growth. This will undoubtedly get reflected in the performance of banks in these regions. Moreover, the increasing possibility of the European Union nearing the end of its ultra-low interest rate environment based on economic improvement raises optimism about its banks’ top-line growth.

While a faster-than-expected pace of interest rate hike in the U.S. and a strengthening dollar will lead to capital outflow and make credit expensive for emerging and developing economies, a recovery in prices for commodities, which many of these economies export, will help them to grow moderately. Consequently, banking activities in these economies should not weaken. According to the IMF, “Stronger activity and expectations of more robust global demand, coupled with agreed restrictions on oil supply, have helped commodity prices recover from their troughs in early 2016.”

Prospects Look Up for Banks in Key Nations

Despite the French election relief rally and investors’ optimism over economic growth and earnings improvement, shares of the major European banks – including Barclays (BCS - Free Report) , Deutsche Bank (DB - Free Report) and Credit Suisse (CS - Free Report) – have underperformed their U.S. counterparts so far this year, as the key interest rates are still ultra-low.

Perked up capital market activity, better business in emerging market operations and support from a trading boom in the U.S. have helped many European banks report improved results in the January-March quarter, overcoming the Brexit gloom. While Deutsche Bank, Royal Bank of Scotland and Barclays witnessed year-over-year improvement in earnings, Credit Suisse returned to profit.

While historic low key interest rates will mar top-line growth and the pain with bad assets on balance sheets will continue, favorable capital market activity and reducing non-core losses should help European banks to show some bottom-line improvement in the quarters ahead.

The prospects of the banks in Japan remain uncertain with the central bank leaving its interest rate unchanged at negative 0.1% at its Mar 2017 meeting and not hinting at future rate rises. The struggle to dodge deflation will likely keep its monetary policy loose for some time. While the economy will keep growing moderately, it’s unlikely to materially benefit the banking system by offsetting the damage caused by the negative rate environment.

Shares of the top three Japanese banks by assets -- Mitsubishi UFJ Financial Group, Inc. (MTU - Free Report) , Mizuho Financial Group, Inc. (MFG - Free Report) and Sumitomo Mitsui Financial Group, Inc. (SMFG - Free Report) – have underperformed the S&P 500’s 7.1% gain so far this year. While Mitsubishi UFJ and Mizuho Financial have gained 3.4% and 2.2%, respectively, Sumitomo Mitsui has lost 4.3%.

As the rising rate environment in the U.S. could create growth headwinds for China due to significant capital outflow from the economy, the Chinese central bank has been raising benchmark rates on its open market operation facilities in an effort to conserve foreign reserves. It also indicates steadiness in the economy. So the rate environment is not so unfavorable for its banks. However, the economy’s credit vulnerability could be risky for its banking system.

Business Realignment and Capital Strength to Aid Growth

While margin compression and sluggish loan growth remain serious dampeners, foreign banks keep repositioning business fundamentals to capitalize on every opportunity. Defensive actions like limiting expenses by contracting operations and retrenching workforce are still in place, and the focus on noninterest income is deepening.

Capital efficiency remains the key to both survival and success, and most foreign banks have been strengthening their capital ratios by dumping non-core assets for quite some time. Further, banks will continue to improve solvency and balance sheet liquidity as they move closer to comply with regulatory capital requirements. Though this will limit their flexibility to invest in new ventures, any growth that they witness will be safe and steady.

Top-Line Pressure to Continue, but Will Alleviate Gradually

While monetary policy cycles in developed nations (except the U.S.) nearing turning points, with some improvement in the economies, the interest rates are unlikely to be favorable for banks any time soon. Naturally, interest-sensitive revenues for banks in these regions are likely to remain under pressure in the upcoming quarters. However, despite regulatory restrictions, there will be some progress on the non-interest revenue front with increasing sources.

Banks in consumption-driven economies, however, may not be significantly challenged by interest income due to a not-too-low interest rate environment which is needed to keep inflation at check.

But capital outflows from these economies with rising interest rates in the U.S. will limit their flexibility in generating non-interest revenues. Also, intense competition from domestic and foreign players will continue to hinder revenue generation.

Further, under President Trump, foreign banks that have significant operations in the U.S. might face stricter supervision. This will curb their benefits from the prospering U.S. economy.

Bottom Line

The rising rate environment in the U.S. might lead to a funding crunch in some economies and their banks will bear the brunt. However, these economies are also showing signs of improvement that may bring a better rate environment for their banks. Effectiveness of cost control and growing overall lending supported by moderate economic improvement might lead to some improvement in their financials in the upcoming quarters.

Cost reductions by job cuts and asset sales will be instrumental in keeping foreign banks afloat and improving global economic data will lead to increased revenues through rising demand. The banks’ aim should be to reposition the business models to grab every opportunity. 
 
Foreign Bank Stocks Worth Buying Now

The industry might not be able to tide over the challenges anytime soon, but there are plenty of reasons to be optimistic about its long-term prospects. Particularly, given the cheap valuation, it’s perhaps the right time to pick a few stocks from this space. Here are a few stocks that have been witnessing positive estimate revisions and carry a Zacks Rank #1 (Strong Buy):

(You can see the complete list of today’s Zacks #1 Rank stocks here.)

Grupo Financiero Galicia S.A. (GGAL - Free Report) : The stock has gained nearly 57% so far this year. The Zacks Consensus Estimate for the current year has been revised 7.4% upward over the last 60 days. Also, the stock surpassed earnings estimates by an average 6.6% over the trailing four quarters.

The Bank of N.T. Butterfield & Son Ltd. (NTB - Free Report) : The stock has seen 6.3% upward revision in the Zacks Consensus Estimate for the current year, over the last 60 days. Also, the company delivered an average positive earnings surprise of 16% over the trailing four quarters. The stock has gained 8.5% so far this year.

Shinhan Financial Group Co. (SHG - Free Report) : The stock has gained over 19% so far this year. It has seen the Zacks Consensus Estimate for the current year revising marginally upward over the last 30 days.

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