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Foreign Banks Stock Outlook - January 2018

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The key short-term concern for foreign banks with significant U.S. operations is the impact of the recent tax overhaul. Similar to the domestic banks, these are being forced to writedown the value of the tax credits they realized for incurring losses in the past, per a provision in the new tax law. These one-time charges will eat into their full-year 2017 profits. However, a lower U.S. corporate tax rate is expected to be positive for their bottom lines in the long run.

Barring this short-term concern, an uptick in this year’s global economic growth, projected by the World Bank, should instill further momentum in the foreign banking space, which ended 2017 with a solid recovery after being a laggard for a long time.

Particularly, the recovery witnessed by banks in advanced nations, fueled by accommodative monetary policy and fiscal stimulus of the central banks, could be self-reinforcing in the quarters ahead. While the central banks gearing up to raise interest rates is a downside to the sustainability of economic growth, it could be a blessing for banks as these thrive in higher rates.

The World Bank currently expects the global economy to grow 3.1% in 2018 after a 3% advancement last year. Though the expected growth rate looks moderate, it’s encouraging to note that the World Bank expects synchronized expansion across all major regions of the world.

Of course, buoyant financial markets will play a major role in driving the growth. And this makes the backdrop favorable for banks in key nations. Particularly, since the perking up of the economies of Japan and Eurozone — homes to the major foreign banks — is the key contributor to the growth, the foreign banking space should hold ample promise.

Financial results from the mega players for the quarters reported in 2017 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 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 over the past two years.

This is clearly evident from the Zacks Foreign Banks Industry’s rally of 62.9% in two years’ time versus the S&P 500’s 50.8% growth.

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 Banks Still Have Upside Left

While the industry has outperformed the broader market over the past two years, 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 1.67 — the highest level in the past two years. When compared with the median level of 1.37 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 4.00 and the median level is 3.46.

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 2.63 and the median level of 2.26 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.

Zacks Industry Rank Indicates Bleak Near-Term Prospects

The group’s Zacks Industry Rank calls for underperformance in the near term. This 70-company industry carries a Zacks Industry Rank #177, which places it at the bottom 31% 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.

The concerns over the impact of Trump’s tax overhaul on full-year 2017 results of foreign banks with significant U.S. operations perhaps led to a downward revision in earnings estimates.

Continued Economic Growth to Bolster Financials

As fears of stagnation in the global economy is now a thing of the past, the stage is set for foreign banks to capitalize on any progress that the global economy witnesses.

IHS Markit expects the global economy to maintain 2017’s 3.2% growth rate this year. While economic growth in Eurozone and Japan is expected to soften in 2018, there is no chance of stagnation. In fact, Eurozone’s expansion is expected to remain solid.

While chances of the European Central Bank 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.

In Japan, persistent weakness of yen will continue supporting exports and a steady growth in consumer spending will keep domestic demand resilient. However, lower chances of inflation reaching the central bank’s target level reduce the possibility of any change in the negative short-term interest rate environment.

China is expected to witness slower growth in 2018, as the government’s “Supply Side Structural Reform” might fall short in addressing the fundamental problems like excess industrial capacity, housing glut and debt overhang. Now, the rising rate environment in the U.S. could create growth headwinds for China due to significant capital outflow from the economy. So the Chinese central bank has been raising benchmark rates in response to the U.S. moves in an effort to conserve foreign reserves. Currently, the rate environment is not so unfavorable for its banks. However, the economy’s credit vulnerability could be risky for its banking system.

As the pace of interest rate hike in the United States is expected to increase and the dollar will strengthen due to the tax overhaul, emerging and developing economies are expected to witness significant capital outflows. However, some support is expected from the rising prices of commodities that many of these economies export. This, along with a sustained pickup in activities in these economies, should help their banks prosper.

What Lies Ahead for Banks in Key Nations

Investors’ optimism over the likely easing of political instability post French election, economic growth and the expectation of higher interest rates, which allow banks to thrive, pushed European stocks higher in the first six months of 2017. But the enthusiasm waned in the second half of the year and the stocks lost ground. 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 over the past year.

However, while the sector is still grappling with huge bad loans and an ultra-low interest rate environment, efficient expense management and better business in emerging market operations have helped many European banks report improved results in the in the last three quarters.

No major support to top line is expected from the rate environment anytime soon, and the pain of bad assets on balance sheets will continue. Yet, 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 December 2017 meeting and not hinting at future rate hikes. In fact, as inflation remains way below the targeted 2%, chances of any rate hike in the near term are dim. This will keep putting pressure on the commercial banks’ interest income. While the economy is expanding moderately, it’s unlikely to materially support the banking system by offsetting the damage caused by the negative rate environment.

Among the top three Japanese bank stocks — Mitsubishi UFJ Financial Group MTU, Mizuho Financial Group (MFG - Free Report) and Sumitomo Mitsui Financial Group — two have underperformed the S&P 500’s 24% gain over the past year. While Mitsubishi UFJ has rallied 24.3%, Mizuho Financial and Sumitomo Mitsui have gained 6.6% and 21.4%, respectively.

Business Realignment and Strong Capital Levels to Power Financials

While foreign banks have been witnessing accelerating 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. 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 to Continue, But Alleviate Gradually

With monetary policy cycles in developed nations (except the United States) yet to reach turning points, the interest rates are unlikely to be favorable for their 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

While the impact of the U.S. tax overhaul makes the near-term prospects bleak for foreign banks, synchronized growth across the major foreign economies and consequent increase in business activities    should keep benefiting foreign banks. Though top-line pressure will take time to alleviate in the absence of any significant support from the interest rate environment, effectiveness of defensive measures and growing overall lending should help foreign banks stay afloat.

Foreign Bank Stocks Worth Buying Now

The industry might not be able to tide over the broader 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 #2 (Buy):

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

Erste Group Bank AG (EBKDY - Free Report) : This stock has gained 62.4% over the past year. The Zacks Consensus Estimate for the current year has been revised 4.5% upward over the last 60 days.

Westpac Banking Corp. (WBK - Free Report) : The stock has seen 4.2% upward revision in the Zacks Consensus Estimate for the current year, over the last 60 days. It has gained 2.7% over the past year.

Banco Macro (BMA - Free Report) : The stock has gained more than 41.8% over the past year. The Zacks Consensus Estimate for the current year has been revised 16.2% upward over the last 60 days.

United Overseas Bank Ltd. (UOVEY - Free Report) : The stock has gained 45.7% over the past year. It has seen the Zacks Consensus Estimate for the current year revising 4.9% upward over the last 60 days.

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