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U.S. Banks Stock Outlook - July 2016

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It might take long for U.S. banks to feel the comfort of higher rates, as the gloom over the global economic backdrop and outlook will likely hold the Fed back from raising rates for a considerable length of time. So it’s better to look beyond this overcooked matter and focus on the factors that are shaping up the industry’s near-term prospects.

Although the headwinds appear stronger than the facilitators, the earnings picture hasn’t been gloomy over the past several quarters. Looking at the second-quarter earnings performance, most of the banks – including JPMorgan (JPM - Free Report) , U.S. Bancorp (USB - Free Report) and BB&T Corp. BBT – that have reported results so far have not only managed to beat estimates but have also shown year-over-year improvement.

However, U.S. banks have not been able to draw investors’ attention lately thanks to a host of issues including renewed interest rate pressure, stressed energy sector lending, strained global economic growth, collapse of commodity prices and the Brexit aftermath. This is clearly evident from the KBW Nasdaq Bank Index’s (BKX) nearly 14% loss in the past one year versus over 4% gain of the S&P 500.

However, spurred demand for loans with an improving domestic economy is the silver lining for the U.S. banks. While margin pressure may not alleviate any time soon given the indifferent interest rate picture, rising loan volume will make up for the loss to some extent. Most importantly, the recuperating financial condition of Americans will minimize default rates on loans.       

Overall, banks are not expected to be relieved of the nonstop cropping up of issues before long. In addition to increasing threats related to cybercrime and unconventional competition, they will keep grappling with the ever-changing regulatory restrictions. Actually, failure to control the cost of business due to so many mandates and defensive actions will mar their profitability.

But banks are not sitting idle. They are continuously attempting to reduce needless expenses by reorganizing business and increasing focus on non-interest revenue sources. Actually, this is how they have been able to deliver decent bottom-line numbers in the past few quarters. Hopefully, the success will make them smarter in the quarters ahead.

However, while expense reduction efforts have been efficient, top-line improvement has yet to show stability. And unless the top line improves steadily, it will be difficult for banks to keep bottom line afloat for long just by cutting costs.     

Key Business Trends

Mortgage Business: A low-rate environment encouraged people to refinance home loans in the past few years. However, refinancing is running out of steam. On the other hand, the purchase loan market has been witnessing slow-but-steady growth over the past two years. Moreover, the first quarter of 2016 marked the 16th consecutive quarter of year-over-year growth in Home Equity Line of Credit (HELOC) originations, according to RealtyTrac. This indicates improving mortgage business for commercial banks.

Though the margin on fresh mortgages is low due to cheap rates and a rise in nonbank lenders, the increasing origination volume should help banks earn decently from the mortgage business.

Trading Activity: Trading activity is likely to remain subdued, particularly given the cautious steps taken by investors amid uncertainties in the global economy. The Brexit storm further fueled the concerns. Overall, the concerns will keep the markets highly volatile in the quarters ahead. And by their very nature, trading volumes and revenues will feel the negative impact of high volatility. Particularly, client activity is expected to be feebler in equities than fixed income.

On the other hand, fixed-income trading, which requires heavy capital, is already shrinking due to less capital flexibility after complying with regulatory requirements.       

Investment Banking: Global investment banking fees – for services like M&A advisory, capital markets underwriting, etc. – fell 23% to $37.1 billion at the end of the first half of 2016, according to Thomson Reuters data. This marks the slowest first half for investment banking fees since 2012. It also points to significant weakness in the U.S. investment banking segment, as five U.S. mega banks hold the majority of the global investment banking market share in terms of revenues.

According to a Thomson Reuters report on this issue, “While 2015 was a record year for M&A, 2016 is shaping up to be a record year for 'broken' deals, as the United States flexes its antitrust muscle and seeks to crack down on deals that aid tax avoidance or risk harming national security.”

Moreover, as investors preferred to stay away from risky assets in the wake of the global rout, demand for IPOs and high-yield bonds reduced. As a result, revenues from advisory and underwriting slowed down. The equities division might continue to slip on a cautious stance by investors until global growth concerns and the volatility triggered by Brexit slacken. Overall, investment banking might not contribute significantly to total revenues in the quarters ahead.
Loan Volumes: As mentioned earlier, loan growth remained a bright spot for the U.S. banks on the back of a low-rate environment. Both business loans and residential mortgages have been showing significant growth over the last few years. While businesses will ramp up borrowing to avoid the expected higher rate environment, an improving labor market, a lower unemployment rate and a recovering housing market should support loan growth in the commercial and real estate space. Moreover, backed by economic recovery, the areas of auto, credit cards and student lending should lift the fortunes of banks.

Legal and Regulatory Costs: The results for the last few quarters show some respite from high legal costs, with the sharp sting of fines and penalties being cured by settlements. Yet U.S. banks will need some more time to free themselves from the clutches of regulators for their wrongdoings. Plus, the rising cost of regulatory compliance is unlikely to be brushed off from the accounts of banks anytime soon. In fact, regulatory scrutiny on the business model of banks and their targeted M&A deals may keep increasing.

Proactive Steps Taken So Far

Against the present backdrop, apart from resorting to defensive measures like expense control, banks are taking some aggressive steps. Primarily, they have been trending toward higher fees to relieve top-line pressure. Balance sheet restoration and easing lending standards after complying with regulatory guidelines is the trend.

Let’s take a quick look at the areas that banks are primarily focusing on:

Mergers and Acquisitions: Compliance expense is bugging almost every bank and the smaller ones in particular are struggling to remain profitable. As a result, large institutions now have immense inorganic growth opportunities. However, a sharper focus on growth prospects and regulatory challenges will be crucial to capitalizing on such opportunities.

Prioritizing Growth: Banks are exploring new strategies such as cross-selling with the help of customer analytics to prioritize growth.

Cyber Security: As data breaches threaten banks, greater resources are being allocated toward cyber security. Though investments in advanced technology are eating away a large share of funds, adopting new methods will be critical from a competitive standpoint.

What the Zacks Industry Rank Indicates

Within the Zacks Industry classification, U.S. banks are broadly grouped in the Finance sector (one of 16 Zacks sectors) and are further sub-divided into six industries at the expanded (aka "X") level: Banks-Major Regional, Banks-Midwest, Banks-West, Banks-Northeast, Banks-Southeast and Banks-Southwest. The level of sensitivity and exposure to different stages of the economic cycle vary for each industry.

We rank 265 X industries in the 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry.

We put our X industries into two groups: the top half (industries with the best average Zacks Rank) and the bottom half (the industries with the worst average Zacks Rank). Over the last 10 years, using a one week rebalance, the top half beat the bottom half by a factor of more than 2 to 1. (To learn more visit: About Zacks Industry Rank.)

The Zacks Industry Rank is #50 for Banks-Southwest, #68 for Banks-Midwest, #72 for Banks-Southeast, #134 for Banks-Northeast, #156 for Banks-West and #222 for Banks-Major Regional.

What to Expect from Q2 Earnings Season?

Over 35% S&P 500 companies in the broader Finance sector, of which U.S. banks are part, have reported second-quarter results as of July 22. The performance looks impressive with the ‘beat ratio’ (percentage of companies coming out with positive surprises) coming at 75% for earnings and 59.4% for revenues. However, earnings and revenues have declined 5.1% and 0.7% year over year, respectively.

The earnings growth expectation for the quarter looks reassuring. The S&P 500 companies in the in the broader Finance sector are expected to witness an earnings decline of just 0.4% in Q2 compared with a 6.9% decline in the prior quarter.

Revenues are expected to decline 0.5% versus a 2.7% increase in the prior quarter.

For a detailed look at the earnings outlook for this sector and others, please read our Earnings Preview report.

Bottom Line

Against an improving economic backdrop, U.S. banks are taking desperate strategic actions to leverage their financials. But mushrooming concerns and increased competition will continue to thwart profitability. Further, significant delay by the Fed in tightening the monitory policy will keep the struggle alive for banks.

On the positive side, banks are getting accustomed to increased legal and regulatory pressure and resorting to safer alternatives for higher returns. In fact, banks are now well capitalized propelled by the regulatory requirements, as evident from the recent passing of stress test by all 33 banks. Though a high capital reserve impairs business expansion, it reduces the chance of collapsing even if the economy witnesses a deep recession.  

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