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The sequentially weaker third-quarter earnings might transitorily hinder the momentum gained by bank stocks since the passage of the Financial CHOICE Act in the House in June and the Treasury’s presentation of its plans to streamline the nation’s banking system.

However, while the proposed wholesale regulatory reform (a full-scale repeal of Dodd-Frank) still awaits action in the Senate, investors’ optimism over a relief to the banking industry caused by repeal should keep the momentum in bank stocks alive. Essentially, lesser regulation will notably reduce the fixed costs that banks are struggling with for long.

This coupled with the impact of a rising rate environment, strengthening U.S. dollar and steady GDP growth on banks’ top line should drive bank stocks higher. Investors’ optimism over potential tax reforms as well as the Federal Reserve’splans to unwind its giant balance sheet will be the other important catalysts.

Though there are a few troubles in the industry, including defaults in the areas of auto and student loans, these should be outweighed by positive economic trends such as rising wages and falling unemployment, and positive industry trends like low mortgage and credit card default rates.

Banks’ results for the July-September period don’t indicate the industry’s growth potential. In fact, similar to the prior quarter, the backdrop wasn’t favorable for banks as evident from the results of the mega players — including JPMorgan (JPM - Free Report) , Bank of America (BAC - Free Report) and Citigroup (C - Free Report) . However, the optimism over the industry’s prospects helped the stocks to outperform the broader markets over the past six months.

The Zacks Major Regional Banks Industry has rallied 11.6% over the past six months versus the 7.5% gain of the S&P 500. Also, the Financial Select Sector SPDR fund (XLF), a top bank ETF, has gained about 12.5% over this period.

How Long Do Banks Need to Wait for a Rebound?

A lot depends on when and in what capacity the wave of financial deregulation falls on the industry.

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 a full-scale regulatory reform getting clearance in the Senate 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 so far.

Benefits from Monetary Policy Should Intensify

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 yields from earning assets. So margins are expected to expand materially in the next couple of years.

Further, the gradual winding down of the Federal Reserve’s $4.5 trillion balance sheet will likely benefit banks in a number of ways, primarily by putting upward pressure on interest rates.

Current Business Trends Show Recovery

Lending: Loan growth at commercial banks rebounded in the last two quarters. According the Federal Reserve’s latest data, commercial banks saw 4.1% and 4.5% annualized growth in loans and leases in Q2 and Q3, respectively, after a sharp decline to 0.9% in Q1. However, the current growth is weaker than the rates seen by the industry in 2015 and 2016. While growth in consumer and real estate loans significantly contributed to the recent rebound, commercial and industrial loan growth remains weak.

Continued uncertainty over Trump’s “wish list” getting clearance and cheaper ways to borrow are among the factors that could keep loan growth sluggish in the months ahead. 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 kept the deposit scenario better than loans. The last three quarters saw a decelerating deposit growth rate, but the rates don’t compare unfavorably with what the industry saw in the last two years. While there is no foreseeable factor that can reduce demand for deposits in the near term, the Fed’s moves will keep increasing competition for deposits.

Expenses: Expense reduction, which has long held the key 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.

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.

Key Business Segments Yet to Show Steadiness

Mortgage Business: As the refinance boom nears its end with the interest rates moving higher, refinancing activities should decline. The Mortgage Bankers Association (MBA) expects refinance originations to decrease more than 28% year-over-year in 2018.

However, the MBA projects purchase mortgage originations to increase more than 7% with more availability of mortgage credit to qualified borrowers amid a decent growth in job and wage.

Overall, the MBA forecast calls for a decline in mortgage originations in 2018.

Trading Activity: Trading activities remained sluggish in the last two quarters, primarily in the absence of any tangible progress on the reforms proposed by the Trump administration, lesser geopolitical tensions and a predictable monetary policy standpoint of the Fed.

Any significant improvement in trading activities is not expected in the quarters ahead. This will particularly keep the related business of trading-intensive banks like Goldman Sachs (GS - Free Report) , JPMorgan and Morgan Stanley (MS - Free Report) muted.

Investment Banking: The trend of pocketing solid advisory and underwriting fees on the back of higher debt origination should continue. As interest rate hike is expected to continue, many U.S. companies have been raising fresh debt capital to avoid higher interest rates later. As debt origination fees typically account for about half of total investment banking fees, this has been leading to strong gains for the largest U.S. investment banks.

On the other hand, lack of equity issuance and M&As will keepthe related fees low for the largest U.S investment banks in the quarters ahead.

Disappointing Q3 Earnings Picture

The latest Earnings Trends paint a disappointing picture for Zacks medium (aka "M") level bank industries — Banks & Thrifts and Major Banks. While earnings growth for Banks & Thrifts is expected to be 17.1% in Q3 (versus 32.8% in Q2), Major Banks will witness meager growth of 6.5% (versus 10%).

Valuation Yet to Reflect Long-Term Prospects

Despite the outperformance of the Zacks Major Regional Banks Industry over the last six months, there is still a solid value-oriented path ahead — particularly, with a rosier long-term outlook. 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 1.68 — near the highest level of 1.69 seen in the last six months. When compared with its own average of 1.51 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 3.83 and the median level is 3.63.

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.

Zacks Industry Rank Indicates Restrained Near-Term Prospects

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

In terms of Zacks Industry Rank, four of these six groups belong to the top 50% of the 250 plus Zacks industries and the other two are in the bottom 50%. 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.

Midwest Banks are placed at the top 19%, Northeast Banks at the top 43%, West Banks at the top 46%, Southwest Banks at the top 47%, Major Regional Banks at the bottom 35% and Southeast Banks at the bottom 16%.

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