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U.S. Banks Stock Outlook - March 2018

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U.S. bank stocks have been receiving a lot of love from investors because of the far-ranging benefits that a rising rate environment, tax overhaul and an expected ease in regulation could bring to the industry. While the latest earnings results hardly displayed progress, the expected future benefits are helping bank stocks outperform the broader market.

The Zacks Major Regional Banks Industry has rallied 19% over the past six months, despite the not-so-impressive earnings results in the last two quarters. This compares with the S&P 500’s gain of 10.8% and 17.7% rally of the Financial Select Sector SPDR fund (XLF), a top bank ETF, over this period.

The likely intensity of rate hikes and the economy getting closer to relaxed banking regulations should keep the momentum in bank stocks alive in the months ahead.

As the bill on rolling back the 2010 Dodd-Frank banking legislation, which reaped bipartisan support last week, is widely expected to soon become law, a number of banks with assets between $50 billion and $250 billion would be exempt from the tough banking regulations. Small and mid-size lenders will benefit the most, as lesser regulations will essentially reduce their fixed costs.

On the other hand, rising inflation expectations might lead to more interest rate hikes than the three predicted by the Fed for 2018. This will lend significant support to top-line growth of banks of all sizes, leading to the stocks moving higher. Moreover, the Fed’s unwinding of its giant balance sheet, though occurring at a slower-than-expected pace, will be another performance driver for bank stocks.

While top-line strength and lower regulatory expenses are likely to result in better earnings for banks, troubles related to defaults in the areas of auto and student loans may not subside anytime soon.  However, these should be outweighed by positive economic trends such as rising wages and falling unemployment.

Expansion in Net Interest Margins Should Continue

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

Since the Fed started raising interest rates, the trend has been to cap the cost of funding by keeping the rates on deposits almost unchanged. On the other hand, lending rates have been directly proportional to the movement of interest rates. As a result, banks have been able to steadily expand net interest margin so far. This trend, which is expected to continue in the upcoming rate-hike cycles, should keep investors happy.

Further, the yield curve, which steepened with the expectation of faster economic growth after the presidential election, should steepen further with interest rate hikes and fiscal stimulus in the form of tax cuts.

Current Business Trends Don’t Look Reassuring

Lending: Loan growth at commercial banks remained steady in the last three quarters of 2017. According the Federal Reserve’s latest data, commercial banks saw 3.5%, 3.9% and 3.4% annualized growth in loans and leases in Q2, Q3 and Q4, respectively, after a sharp decline to 2% in Q1. However, final two months of 2017 show sluggishness. Also, the growth rates witnessed in the last few quarters are weaker than the rates seen by the industry in 2015 and 2016. While growth in consumer loans significantly contributed to the recent growth, commercial and industrial loan growth remained weak.

However, the tax overhaul is expected to uplift overall loan demand to some extent. Further, 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, but the last four quarters saw a decelerating deposit growth rate. In fact, deposit growth significantly slowed down in the final two months of 2017. The Fed’s moves will keep increasing competition for deposits in the months ahead.

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. In fact, since banks will be less regulated going forward, there will be lower compliance costs.

On the other hand, 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 Show Strength

Mortgage Business: With the interest rates moving higher, refinancing activities have been slowing down. However, the Mortgage Bankers Association (“MBA”) expects overall originations to increase in the next couple years. While refinances will decline during this period, purchase originations are expected to reach the highest levels since 2016.

The MBA projects purchase mortgage originations to increase 6% year over year in 2018 with more availability of mortgage credit to qualified borrowers amid decent growth in jobs and wages.

Trading Activity: After three straight quarters of muted activities, it appears that volatility is back in the markets. Last month, the markets experienced the worst single-day plunge in about seven years and the 10-year Treasury yield hit a four-year high. These indicate higher trading activities and increased trading revenues primarily for big banks.

This will particularly benefit trading-intensive banks like Goldman Sachs (GS - Free Report) , JPMorgan (JPM - Free Report) , Morgan Stanley (MS - Free Report) and Bank of America (BAC - Free Report) in the upcoming quarters.

Investment Banking: The trend of pocketing solid advisory and underwriting fees for debt and equity issuance may reverse, as rising rates will slow down corporates’ involvement in these activities in the upcoming quarters. As debt origination fees typically account for about half of total investment banking fees, this could deal a blow to the largest U.S. investment banks.

However, a potential increase in fees from increasing M&As in select sectors should help the largest U.S. investment banks to partially offset the lost revenues.

Valuation Indicates Plenty of Upside

Despite the outperformance of the Zacks Major Regional Banks Industry over the past six months, there is still a solid value-oriented path ahead. 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 1.87 — near the highest level of 1.94 seen in the last six months. When compared with its own average of 1.75 over that period, the industry doesn’t appear to have any major upside.

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 3.90 and the median level is 3.75.

As finance stocks typically have a lower P/B ratio, comparing 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 still undervalued. The Zacks Finance Sector’s trailing 12-month P/B ratio of 2.64 and the median level of 2.58 over the same period are way above the Zacks Major Regional Banks Industry’s respective ratios.

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

Zacks Industry Rank Doesn’t Indicate Rosy 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, only three of these six groups belong to the top 50% of the 250 plus 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.

Midwest Banks are placed at the top 35%, West Banks at the top 41%, Major Regional Banks at the top 43%, Northeast Banks at the bottom 31%, Southeast Banks at the bottom 22% and Southwest Banks at the bottom 4%.

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