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U.S. Banks Stock Outlook - March 2017

Kalyan Nandy

President Trump’s policy goals and the Fed’s stance on the interest rate front have prompted a huge rally for U.S. bank stocks since the Nov 8 election. The expectation of softer financial regulations, a big tax reduction, significant infrastructure investment and quicker rate hikes have motivated investors to pour money into bank stocks during this period.

Led by mega players like Bank of America (BAC), JPMorgan Chase (JPM) and Wells Fargo (WFC), the Zacks categorized Banks-Major Regional industry rallied 26.8% since Trump's victory versus 10.5% gain of the S&P 500. Also, the Financial Select Sector SPDR fund (XLF), a top bank ETF, gained 17.9% over this period.

This solid performance was supported by the industry’s fundamental progress too. Healthy increases in fourth-quarter profits by mega banks boosted investors’ confidence. Particularly, a rising rate environment, which makes loans lucrative for banks, assured investors of banks’ profitability growth in the upcoming quarters.

The Fed’s recent rate hike for the third time since the financial crisis and its commitment to raise rates faster (two more times) this year based on a convincing pace of economic growth should help banks get rid of shrinking margins – which has been the key challenge since the crisis.

How Long Might the Rally Last?

A lot depends on to what extent Trump lives up to his promises. Bank stocks may be hit hard if he doesn't deliver on certain policy goals. There is absolutely no reason to be pessimistic about the prospect of bank stocks so far since the President has already signed two directives – review of the Dodd-Frank Act and delay in implementing the fiduciary rule.

While Dodd-Frank rules have improved safety in the financial industry, it has reduced banks’ flexibility to do business and significantly increased their compliance costs. On the other hand, the fiduciary rule requires advisors to act in the best interest of their clients, not for their companies. Though both the rules have upside from a defensive perspective, they are in no way business friendly for banks.

Further, banks’ excess reserve at the Fed could bring them solid revenues, as they may not be restricted from engaging in traditional lending activities under Trump’s policies.

The Fed’s actions on expediting rate hike – which is again a function of economic growth based on Trump’s policy alterations – will also play a major role in keeping the optimism on bank stocks alive.

Have Major Bank Stocks Gone Out of Reach?

While the Banks-Major Regional industry significantly outperformed the broader market over the last six months, 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 1.54 – close to the highest level of 1.61 seen in the last six months. When compared with its own average of 1.47 over that period, any further upside looks unlikely.

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 at 3.57 and the median level is 3.38.

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

The group’s Zacks Industry Rank confirms this view. This 16-company industry currently carries a Zacks Industry Rank of #80, which places it at the top 31% of the 250 plus Zacks classified 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.

Zacks Industry Rank for Other Banking Groups

Other than the Banks-Major Regional industry, U.S. banks are grouped into five industries at the expanded (aka "X") level – 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.

In terms of Zacks Industry Rank, four of these five groups are better positioned than Banks-Major Regional.

Of these industries, Banks-Northeast is placed at top 11%, Banks-Midwest at top 12%, Banks-West at top 12%, Banks-Southeast at top 18% and Banks-Southwest at top 43%.          

Key Business Trends

Lending: Despite easing lending standards a number of times last year, overall loan growth has slowed in the last few months. According the Federal Reserve’s latest data, since Nov 2016, commercial banks have seen the weakest loan growth in five years. While growth in consumer loans remained strong, commercial and industrial credit growth shrank significantly.

Perhaps uncertainty over Trump’s policy goals and cheaper ways to borrow are among the factors responsible for this weakness. Investors’ ‘wait and see’ attitude could keep the lending scenario bleak in the coming months. However, wage growth and higher disposable income as a result of improving economy should eventually increase retail and small business lending opportunities.

Deposits:Relatively less-levered consumers and businesses along with economic growth and improvement in labor and housing markets have spurred growth in deposits. However, the liquidity coverage ratio requirements that force banks to pay premium on stable funding will increase costs for the deposits.

Expenses: U.S. banks are continuously attempting to reduce needless expenses by reorganizing business. Actually, this is how they have been able to deliver decent bottom-line numbers in the past few quarters. Hopefully, the experience will make them smarter in the quarters ahead. Also, 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. While scrutiny on the business model of banks and their targeted M&A deals may prevail and technology cost will keep on increasing, expected softer regulations in the Trump era will reduce compliance costs.

How Key Business Segments Should Perform

Mortgage Business: An expected higher rate environment and less-concerned lenders over regulatory restrictions will drive demand for refinancing in the quarters to come. According to the Mortgage Bankers Association’s builder application survey, mortgage applications for new home purchases increased in February on a year-over-year basis. Further, with the strong appetite of lenders and borrowers, commercial and multifamily mortgage loan originations are expected to improve this year.

Trading Activity: Trading activity was strong in the fourth quarter. Particularly, fixed-income trading activity soared after the presidential election. In fact, after a prolonged weakness, fixed income, currency and commodity (FCC) trading rebounded in 2016. Uncertainty related to Trump's policy changes should lead to better trading in the quarters ahead. This will particularly benefit trading-intensive banks like Goldman Sachs (GS), JPMorgan and Morgan Stanley (MS).

Investment Banking: Though JPMorgan earned the majority of fees in global investment banking in 2016, overall investment banking business in the U.S. remained weak. However, the rising rate environment could trigger M&A deals, as companies will try to cut deals before the cost of borrowing shoots up. Further, more startups may try to go public. And an increase in M&A and IPOs means more advisory fees for big banks.

Early Prediction of Q1 Earnings

The S&P 500 stocks in the broader Finance sector, which include all banks, registered a 16.6% year-over-year earnings improvement in fourth-quarter 2016. Banks contributed significantly to the growth with the medium (aka "M") level industries, Banks & Thrifts and Banks-Major, witnessing earnings growth of 23.7% and 12.5%, respectively.

Though it’s too early to predict the results for the current quarter, our Earnings Trends report paints a disappointing picture for banks. While earnings growth for Banks & Thrifts are expected to decline to 14.9% in first-quarter 2017, Banks-Major’s earnings growth will likely subside to just 1%.

Bottom Line

Against an improving domestic economic backdrop, U.S. banks are taking desperate strategic actions to power their financials. But mushrooming concerns and increasing competition will continue to thwart profitability. However, a favorable rate environment might lend a major support.

On the other hand, the Trump presidency may bring better days for banks faster with pro-growth policies and softer regulations.  

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