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Industry Outlook

U.S. banks continue to reel under intense net interest margin pressure and an unfavorable industry backdrop, but have gained some traction lately on their success in growing consumer lending and reducing costs. Moreover, relatively less-levered consumers and businesses along with economic growth and improvement in labor and housing markets have spurred growth in deposits and fortified asset quality.

The positive developments in Q3 pared up with the expectation of softer regulation and quicker rate hike under the new president to make bank stocks attractive to investors. This is clearly evident from the Zacks categorized Banks-Major Regional industry’s 12.9% gain over the past six months versus just 7.9% gain of the S&P 500.

While bank stocks are unlikely to end their run in the near term, the rally may not last long. This is because President-elect Donald Trump’s ambiguity over structural bank changes and financial policy could offset the benefits of a likely repeal or significant alteration of the Dodd-Frank Act and higher rates.

Looking at the fundamentals, the headwinds remained stronger than the facilitators, particularly due to the still-struggling energy sector, continued commodity price recession, strained global economic growth and the Brexit aftermath. However, the earnings picture hasn’t been gloomy over the past several quarters. In fact, the recently released results from banks were quite encouraging. Most of the mega banks – including JPMorgan (JPM - Free Report) , Citigroup (C - Free Report) , Bank of America (BAC - Free Report) , U.S. Bancorp (USB - Free Report) and BB&T Corp. (BBT - Free Report) – surpassed earnings estimates in the latest reporting cycle. Results from a decent number of banks improved over the year-ago period too.

While overall loan growth remained sluggish during Q3 primarily due to political uncertainty, all major mortgage lenders witnessed growth in originations. This trend may continue in the near term as well, but efforts to increase consumer lending and rising demand for loans with an improving domestic economy should make banks better off in the medium term.

While margin pressure may not alleviate any time soon given the indifferent interest rate picture, a better loan volume will make up for the loss to some extent. Most importantly, the recuperating financial condition of Americans should gradually minimize default rates on loans.

The biggest catalyst could be the likely relief from the regulatory yoke in Trumpworld. Banks’ excess reserve at the Fed can bring them solid revenues, as they will not be restricted from engaging in traditional lending activities.

On the flip side, banks are not expected to be relieved of a host of emerging issues before long. Increasing threats related to cybercrime and unconventional competition will keep curbing their business growth.

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 gets support from a higher rate environment, 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 and less-concerned lenders over regulatory restrictions will lead to a surge in demand for refinancing in the quarters to come. The purchase mortgage market, which has been witnessing slow-but-steady growth over the past two years, is unlikely to get any boost in the near team. However, according to the Mortgage Bankers Association, commercial and multifamily mortgage loan originations have shown year-over-year improvement in the first nine months of 2016. A low rate environment and strong property fundamentals should keep the trend alive in the near term.

Trading Activity: Trading activity was encouraging in Q3. While equities trading remained relatively muted during the quarter, higher fixed income, currency and commodity (FCC) trading led to growth in overall trading revenues. Uncertainty caused by Trump's victory should lead to better FICC trading in the quarters ahead. This will particularly benefit trading-intensive banks like Goldman Sachs, JPMorgan and Morgan Stanley.

Investment Banking: Five largest U.S investment banks earned 31% of the total investment banking fees (i.e. revenues from services like M&A advisory, capital markets underwriting, etc.)generated by the industry in Q3, according to a Trefis article. This compares unfavorably with 34% in the prior quarter and 35% in year year-ago quarter. Moreover, it points to continued weakness in the U.S. investment banking segment. While equity underwriting fees remained unchanged sequentially, fees from M&A advisory and debt origination declined marginally.

M&A activity showed only a modest improvement during 3Q. With traditional acquirers’ continued focus on portfolio repositioning instead of acquisitions for growth, no significant improvement in M&A activity is expected in the quarters ahead.

Further, as investors preferred to stay away from risky assets amid global growth concerns, demand for IPOs and high-yield bonds reduced. As a result, revenues from advisory and underwriting will remain subdued. The equities division might continue to slip on a cautious stance by investors until global growth concerns slacken. Overall, investment banking might not contribute significantly to total revenues in the quarters ahead.

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. While scrutiny on the business model of banks and their targeted M&A deals may continue, regulations are expected to be eased in the Trump era, helping banks to transition from defensive to more aggressive actions.

Proactive Steps Taken So Far

Against the present backdrop, apart from resorting to defensive measures like expense control, banks are taking some ardent 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 #24 for Banks-Midwest, #34 for Banks-Northeast, #60 for Banks-Major Regional, #74 for Banks-Southeast, #156 for Banks-West and #162 for Banks-Southwest.

Early Prediction of Q4 Earnings

All S&P 500 banks, which are part of the broader Finance sector, have just reported their Q3 results. The sector registered a 12.2% year-over-year earnings improvement. Banks contributed significantly to the growth with the medium level industries, Banks & Thrifts and Banks-Major, witnessing earnings growth of 33.2% and 5.3%, respectively.

Though it’s too early to predict the results for the upcoming quarter, our Earnings Trends report doesn’t show a reassuring picture. While earnings growth for Banks & Thrifts are expected to decline to 10.9% in Q4, Banks-Major will likely report an earnings decline of 4.6%.

Bottom Line

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

On the positive side, a Donald Trump presidency may bring better days for banks faster with a quicker rate hike and softer regulations. In any case, banks are getting accustomed to increased legal and regulatory pressure and resorting to safer alternatives for higher returns.  

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