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U.S. bank stocks, which ran out of steam in the last few months after a huge rally following Donald Trump’s presidential victory, might see a solid rebound in the coming months. That’s because the uncertainty over President Trump delivering on his promised advantageous backdrop for banking business has started reducing with the passage of the Financial CHOICE Act in the House, and the Treasury presenting its plans to streamline the nation’s banking system.

While the proposed wholesale regulatory reform (a full-scale repeal of Dodd-Frank) getting clearance in the Senate and being signed into law might be a tall order, it appears that the Trump administration would be able to make a number of changes even if the proposals don’t get converted to legislation. If that happens, the fixed costs that banks are struggling with will reduce notably.

This coupled with the corporate tax reform, which is more likely to become reality, and rising interest rates should give solid boost to banks’ profitability and take their stocks to heights never achieved before.

The renewed optimism has helped bank stocks recover recently to narrow the gap with the broader market. The Zacks categorized Banks-Major Regional industry has rallied 6.5% since the beginning of the year versus the 8.5% gain of the S&P 500. Also, the Financial Select Sector SPDR fund (XLF - Free Report) , a top bank ETF, has gained 6.7% over this period.

Banks’ second-quarter 2017 earnings reports, which have started coming out recently, might not indicate the industry’s growth potential as there was no tangible progress related to the reforms during the April-June period. In fact, the quarterdoesn’t appear to have offered a favorable backdrop for banks as evident from the results of the mega players — including JPMorgan Chase (JPM - Free Report) , Wells Fargo (WFC - Free Report) and Citigroup (C - Free Report) — that have reported so far. But one of the key factors offsetting the challenges was rising interest rates; the banks appear to have evaded shrinking margins — the key challenge since the crisis.

How Long Might a Turnaround Take?

A lot depends on when and to what extent the reforms proposed by the Trump administration come into effect.

A rising rate environment — at the expected pace — itself has the potential to take banks’ profitability to higher levels through sustained expansion in net interest margins. So it might not take long for the industry to thrive. However, for receiving a bigger boost, corporate tax and financial regulatory reforms have to be in play.

While chances of all the regulatory changes proposed by the Trump administration getting clearance are dim, any permitted change will take years to get fully implemented. We don’t expect any impact of the likely changes on banks’ costs and profitability through the end of this year, considering the progress made by the administration so far.

Interest Rates Hold the Key to Success

Yields on key earning-assets — securities and loans — are expected to rise as interest rates move higher. But a material improvement in margins will depend on the extent to which higher rates put pressure on funding costs — particularly, costs of maintaining deposits. Also, increasing competition will lead to weakening credit quality in the long run.

Considering the industry’s current interest rate sensitivity level, which isn’t impressive as banks have yet to fully return to the rate-dependency level that they trimmed in a prolonged low rate environment, we don’t expect increase in deposit costs and weakening credit quality to significantly mitigate the benefits of higher-earning asset yields. So margins are expected to expand materially in the next couple of years.

Current Business Trends Show Weakness

Lending: Loan growth for commercial banks has slowed in the last three quarters. According the Federal Reserve’s latest data, in the last few quarters, commercial banks have seen the weakest loan growth since 2014. The weakness in growth was lesser in the consumer segment than what commercial and industrial witnessed.

Perhaps continued uncertainty over Trump’s ‘wish list’ getting clearance and cheaper ways to borrow are among the factors responsible for this weakness. Investors’ ‘wait and see’ attitude could keep the lending scenario bleak in the coming months. However, wage growth and higher disposable income as a result of an improving economy should eventually push up demand for retail and small business loans.

Deposits: Relatively less-levered consumers and businesses along with economic growth and improvement in labor and housing markets have spurred growth in deposits. However, the liquidity coverage ratio requirements that force banks to pay premium on stable funding will increase costs for the deposits.

Expenses: Expense reduction, which has long been the key method to remain profitable, may not be a major support going forward, as banks have already cut the majority of unnecessary expenses. However, the results for the last few quarters show some respite from high legal costs, with the sharp sting of fines and penalties being cured by settlements.

Scrutiny on the business model of banks and their targeted M&A deals could lead to some compliance costs. Also, technology costs will keep on increasing.

Performance of Key Business Segments Could Be Lackluster

Mortgage Business: Expectations of a higher rate environment and likely relaxation of regulatory restrictions might keep encouraging refinancing activities in the quarters to come, helping banks to generate some mortgage revenues. However, with the refinance boom nearing its end, no major support is expected from this segment. The latest weekly mortgage applications’ surveys by the Mortgage Bankers Association (MBA) show continued decline in the refinance share of mortgage activity.

Moreover, last month, the MBA projected a 3% year-over-year decline in commercial and multifamily mortgage originations volume in 2017. However, the association expects commercial/multifamily mortgage debt outstanding to increase 2% in 2017.

Trading Activity: For the major part of second-quarter 2017, trading activities remained sluggish in the absence of any tangible progress on the reforms proposed by the Trump administration, lesser geopolitical tensions and an unchanged monetary policy standpoint of the Fed. However, the market witnessed some volatility at the very end of the quarter induced by renewed reform talks and steps.

The key factor driving market volatility could be the headway that the Trump administration has made with the proposed reforms. So any significant improvement in trading activities is not expected in the quarters ahead. This will particularly keep the business of trading-intensive banks like Goldman Sachs (GS - Free Report) , JPMorgan and Morgan Stanley (MS - Free Report) muted.

Investment Banking: Though JPMorgan maintained its top position in terms of earning fees in global investment banking in second-quarter 2017, the overall investment banking business in the U.S. was not impressive during the quarter with lack of equity issuance and M&As.

As cost of borrowing is shooting up with interest rates moving higher, the upcoming quarters may witness sluggish M&A deals and IPOs. This will keep big banks’ fee income from advisory under pressure.

What’s in Store for Banks in Q2 Earnings?

Our latest Earnings Preview report paints a disappointing picture for Zacks medium (aka "M") level bank industries — Banks & Thrifts and Banks-Major. While earnings growth for Banks & Thrifts are expected to be 18% in Q2 (versus 31.2% in Q1), Banks-Major will witness meager growth of 4.5% (versus 19.4%).

Long-Term Positives Yet to Be Priced-In

With the Zacks Banks-Major Regional industry underperforming the broader market over the last six months, there is a solid value-oriented path ahead — particularly, with the long-term profitability outlook being far rosier now. 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, confirms this view.

The industry currently has a trailing 12 month P/B ratio of 1.55 – close to the highest level of 1.61 seen in the last six months. When compared with its own average of 1.42 over that period, any further upside 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 3.67 and the median level is 3.59.

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 positioning calls for a solid upside.

The group’s Zacks Industry Rank confirms this view. This 16-company industry currently carries a Zacks Industry Rank of #74, which places it at the top 29% of the 250 plus 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.

Ranks of Other Banking Groups Shows Promise

Other than the Banks-Major Regional industry, U.S. banks are grouped into five industries at the expanded (aka "X") level – Banks-Midwest, Banks-West, Banks-Northeast, Banks-Southeast and Banks-Southwest. The level of sensitivity and exposure to different stages of the economic cycle vary for each industry.

In terms of Zacks Industry Rank, two of these five groups are better positioned than Banks-Major Regional.

Of these industries, Banks-Southwest is placed at the top 13%, Banks-Midwest at the top 27%, Banks-West at the top 30%, Banks-Southeast at the top 35% and Banks-Northeast at the top 37%.

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