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The foreign banking space is heating up with economic growth gaining momentum across most advanced nations, which have been laggards in the global marketplace for a long time. While accommodative monetary policy and fiscal stimulus are propelling growth, an improving labor market scenario and strengthening global trade are ensuring sustainability.

The median forecast of economists surveyed by Bloomberg depicts global GDP growth of 3.4% in 2017 and 3.5% in 2018. This indicates a sharp increase from 3.1% in 2016. Of course, buoyant financial markets are playing a major role in driving growth. And this makes the backdrop favorable for banks in key nations.

Particularly, perking up of the economies of Japan and Eurozone — home to the major foreign banks — being the major contributor to the growth, the foreign banking space is showing a lot of strength.

Financial results from the mega players for the two quarters completed this year were impressive. 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.

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 expectations 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 so far this year.

This is clearly evident from the Zacks Foreign Banks Industry’s year-to-date rally of 17.5% versus the 11.2% gain of the S&P 500. However, looking back at the past three years, the industry lost 3% while the S&P 500 gained 26.4%.

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

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 1.53 — the highest level since the beginning of the year. When compared with the median level of 1.48 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 ratio for the S&P 500 is at 3.66 and the median level is 3.59.

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 a comparison of the group’s P/B ratio with that of its border sector ensures that the group is undervalued. The Zacks Finance Sector’s trailing 12-month P/B ratio of 2.37 and the median level of 2.33 over the same period are way above the Zacks Foreign Banks Industry’s respective ratios.

Overall, while the valuation from a P/B perspective looks stretched when compared with the industry’s own range since the beginning of the year, 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 70-company industry carries a Zacks Industry Rank #32, which places it at the top 13% of more than 250 Zacks 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.

Economic Growth to Bolster Business Gains

The International Monetary Fund’s (IMF) July update of World Economic Outlook kept global economic growth projections unchanged at 3.5% for 2017 and 3.6% for 2018, but changed the country-level contributions. In fact, these changes go in favor of foreign banks, as the growth projections have been revised up for the two key economies — Eurozone and Japan — that consist a number of major foreign banks. This pickup is expected to stem from a rebound in investment, manufacturing and trade in these economies.

While chances of the European Central Bank (ECB) raising interest rates by the end of 2018 are dim due to still-low inflation, any further loosening of its monetary policy is not expected. So, European banks may not benefit from the rate environment any time soon, but they are well positioned to capitalize on the economic improvement.

The growth projection for China has also been revised up based on a strong first quarter and expected continuation of fiscal support. However, the assumption of a less expansionary fiscal policy led to a downward revision of U.S. growth projections.

As the pace of interest rate hike in the United States is expected to be slow and U.S. dollar continues to weaken, emerging and developing economies are unlikely to witness significant capital outflows. But no major support is expected from the prices of commodities that many of these economies export, as the rebound in the second half of 2016 is gradually fading. However, the IMF expects a sustained pickup in activities in these economies. Consequently, banks in these economies should continue to prosper.

The Bank of Canada recently raised its interest rate for the second time in less than two months based on broadly-based and self-sustaining economic growth. This should be a major support for its banks.  

Prospects of Banks in Key Nations

Despite investors’ optimism over economic growth and improvement in corporate earnings, shares of some of the major European banks — including Barclays (BCS - Free Report) , Deutsche Bank (DB - Free Report) and Credit Suisse (CS - Free Report) — have underperformed the S&P 500 so far this year, as the key interest rates are still ultra-low.

However, efficient expense management and better business in emerging market operations have helped many European banks report improved results in the in the last two quarters.

While no major support to top line is expected from the rate environment any time soon and the pain with bad assets on balance sheets will continue, favorable capital market activity and reducing non-core losses should help European banks show some bottom-line improvement in the quarters ahead.

The prospects of banks in Japan remain uncertain with the central bank keeping its interest rate unchanged at negative 0.1% at its July 2017 meeting and not hinting at future rate rises. In fact, it revised inflation forecasts downward for this fiscal year and the next, reducing chances of any rate hike. Actually, the struggle to dodge deflation will compel the Bank of Japan to keep its monetary policy loose for some time, putting pressure on the commercial banks’ interest income. While an upward revision in GDP expectations indicates moderate economic expansion, 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 11.2% gain so far this year despite showing improvements in financials. While Mitsubishi UFJ has gained marginally, Mizuho Financial and Sumitomo Mitsui have lost 4.2% and 1.1%, respectively.

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 in response to the U.S. moves in an effort to conserve foreign reserves. This also indicates steadiness in the economy. As the hike in interest rates is expected to be sluggish in the United States going forward, the People's Bank of China might take a breather. Currently, the rate environment is not so unfavorable for its banks. However, the economy’s credit vulnerability could be risky for its banking system.

Support from Business Realignment and Strong Capital to Continue

While foreign banks have been witnessing improvement in loan growth on the back of improving economic conditions, margin compression remains a concern. As a result, these banks are continuing with the efforts to reposition business fundamentals to tap every opportunity. Defensive actions like limiting expenses by contracting operations and retrenching workforce are still in place. Also, foreign banks are deepening their focus on noninterest revenue sources.

Capital efficiency, which most foreign banks are gaining by dumping non-core assets for quite some time, remains the key to both survival and success. 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 along the way will be safe and steady.

Top-Line Pressure Will Take Time to Alleviate

With monetary policy cycles in developed nations (except the United States) nearing turning points and notable 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 in check.

But capital outflows from these economies with rising interest rates in the United States 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 United States might face stricter supervision. This will curb their benefits from the prospering U.S. economy.

Bottom Line

As most foreign economies are showing signs of improvement, their banks might benefit from increasing business activities. In fact, economic improvement might eventually bring a better rate environment for the banks. For now, effectiveness of cost control and growing overall lending supported by economic improvements should help foreign banks stay afloat.

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.)

Canadian Imperial Bank of Commerce (CM - Free Report) : The stock has gained 7.3% so far this year. The Zacks Consensus Estimate for the current year has been revised 7.8% upward over the last 60 days. Also, the stock surpassed earnings estimates by an average 4.2% over the trailing four quarters.

HSBC Holdings (HSBC - Free Report) : The stock has seen 6.9% upward revision in the Zacks Consensus Estimate for the current year, over the last 60 days. It has gained 21.5% so far this year.

KB Financial Group (KB - Free Report) : The stock has gained more than 32% so far this year. The Zacks Consensus Estimate for the current year has been revised 18.9% upward over the last 60 days.

Shinhan Financial Group (SHG - Free Report) : The stock has gained 15.3% so far this year. It has seen the Zacks Consensus Estimate for the current year revising 9.7% upward over the last 60 days.

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