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Foreign Banks Stock Outlook - May 2018

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Normalization of monetary policy by some central banks across the globe should keep the momentum alive in the foreign banking space, which ended 2017 with a decent recovery. However, overall growth prospects of foreign banks are being called into question because of the weak recovery witnessed by banks in advanced nations (apart from the United States).

Monetary policy normalization varies across nations, with advanced countries — which are homes to a number of major foreign banks — specifically lagging. The central banks of these economies are yet to take the interest rates to a level that could benefit their commercial banks.

On the other hand, while central banks in some nations are gearing up to raise interest rates, this may act against the sustainability of economic growth that the world has been witnessing. And any sluggishness in global economic growth could dampen the prospects for growing banking activities.

Thankfully, things don’t look displeasing on the economic growth front so far. In fact, the International Monetary Fund (IMF) expects global economic growth to inch up to 3.9% in 2018 from 3.8% in 2017. Further, the fund expects tax cuts in the United States to stimulate global economic activity in the near term. While the expected acceleration in 2018 looks moderate, it’s encouraging to note that the growth for 2017 was the fastest in six years.    

Of course, buoyant financial markets will play a major role in driving growth. And this should make the backdrop favorable for banks across the globe. However, some of these banks — the European and Japanese ones — also require a favorable interest rate environment to thrive in.    

Financial results from the mega players were decent in 2017, but not attractive enough for investors. Profits were primarily driven by strong capital market results as global economic data held up well. Stability in financial markets and optimism over global economic growth led to increased investor appetite for trading activity as well.

A measurable progress in overcoming the setback that most major economies have been witnessing for quite some time is making investors increasingly optimistic. This, coupled with expectations of improving profit margins with lessening policy difficulties in some economies, and increasing demand from relatively less levered consumers and businesses, has helped foreign bank stocks generate positive returns over the past year. But they significantly underperformed the broader market and their U.S. counterparts that got ample support from their domestic operating and policy environment.

The Zacks Foreign Banks Industry has risen just 6.8% over the past year versus the S&P 500’s 13.1% rally.

Before we delve a little deeper into the industry’s current backdrop and assess its prospects, let’s take a look at where the Zacks Foreign Banks Industry stands from a valuation viewpoint.

Foreign Bank Stocks Are Trading Cheap

As the industry has underperformed the broader market over the past year, the valuation looks really cheap now. One might get a good sense of the industry’s relative valuation by looking at its 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.

The industry currently has a trailing 12-month P/B ratio of 1.40, which is the low level over the past year. When compared with the highest level of 1.71 and median level of 1.50 over that period, there is apparently plenty of upside left.

The space also looks inexpensive when compared with the market at large, as the trailing 12-month P/B ratio for the S&P 500 is 3.83 and the median level is 3.67.

As finance stocks typically have a lower P/B ratio, comparing foreign banks with the S&P 500 may not make sense to many investors. But a comparison of the group’s P/B ratio with that of its border sector ensures that the group is trading at a decent discount. The Zacks Finance Sector’s trailing 12-month P/B ratio of 2.54 and the median level of 2.53 over the same period are way above the Zacks Foreign Banks Industry’s respective ratios.

Zacks Industry Rank Indicates Bleak Near-Term Prospects

The group’s Zacks Industry Rank indicates that the underperformance might continue in the near term. This 70-company industry carries a Zacks Industry Rank #213, which places it at the bottom 17% 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.

Global Economic Growth May Not Significantly Support Foreign Banks

As fear 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.

While economic growth in Eurozone and Japan is expected to soften in 2018, there is no chance of stagnation. However, with these two regions being homes to a number of major foreign banks, the industry may not see any significant improvement. 

While the European Central Bank is not expected to further loosen its monetary policy, the chances of it raising interest rates by the end of 2018 are dim due to still-low inflation. Though economic improvement might slightly benefit European banks, the rate environment will remain a headwind.

In Japan, the persistent weakness in yen will continue supporting exports and 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 United States could create growth headwinds for China, as there will be significant capital outflows 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.

With interest rates rising in the United States, 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.

Prospects of Banks in Key Markets

As the economic data may not allow the European Central Bank to restrict monetary stimulus anytime soon, the struggle for banks in this region may continue. While profitability of some Eurozone banks is picking up slowly, margin pressure will continue due to the flattening of the yield curve. Looking at the performance of European bank stocks, shares of some of the major ones — including Barclays (BCS - Free Report) and Deutsche Bank DB — have underperformed the S&P 500 over the past year.

The prospects of banks in Japan remain uncertain, with the central bank — Bank of Japan — keeping its interest rate unchanged at negative 0.1% at its April 2018 meeting and not hinting at any timeline for rate hikes. While the economy is expected to continue expanding moderately, inflation remains way below the central bank’s target. As a result, chances of any rate hike in the near term are dim. This will keep putting pressure on the commercial banks’ interest income.

Shares of some of the major banks in Japan — including Mizuho Financial Group MFG — have underperformed the S&P 500 over the past year.

How to Play Foreign Bank Stocks

The industry might not be able to tide over the broader challenges anytime soon. So it may not be a good idea to bet on this space right now. While one could take advantage of the cheap valuation to benefit in the long run, avoiding stocks that have been witnessing negative estimate revisions and carry a Zacks Rank #4 (Sell) or 5 (Strong Sell) is prudent. Here are a few stocks that carry a Zacks Rank #5:

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

Nordea Bank AB NRBAY: This stock has lost 22.7% over the past year. The Zacks Consensus Estimate for the current year has been revised 6.2% downward over the last 60 days.

UBS Group AG UBS: The stock has seen 13.5% downward revision in the Zacks Consensus Estimate for the current year, over the last 60 days. It has plummeted 2.5% over the past year.

The Royal Bank of Scotland RBS: This stock has gained 15.5% over the past year. The Zacks Consensus Estimate for the current year earnings has been revised 12.5% downward over the last 60 days.

HDFC Bank Limited HDB: The stock has gained more than 15% over the past year. The Zacks Consensus Estimate for the current year has been revised 3.4% downward over the last 60 days.

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