U.S. Banks Stock Outlook - December 2015

Consistent earnings performance over the past several quarters and supportive macroeconomic elements are convincing enough to assume that U.S. banks are about to reach the trajectory of consistent growth. While U.S. bank stocks have climbed significantly since bottoming out during the last financial crisis on the back of an impressive financial performance, the industry’s success trail hasn’t been consistent due to the nonstop cropping up of issues. 

Banks are not expected to be relieved of issues going forward either. Along with the ramifications of past wrongdoings, a host of new issues -- cybercrime, regulatory compliance and unconventional competition, to name a few -- have been denting the financials and will continue doing so. But a sharper focus on reducing needless expenses by reorganizing business and an increased focus on revenues to boost the bottom line are gradually making the growth path steadier.

Further, the benefit from reserve releases is gradually fading away with the significant run down of reserves for the majority of banks. So banks’ core earnings power is better reflected in their recent results. Banks had to resort to reserve releases in the last several years in order to offset the effects of weak demand and an ultra-low interest rate environment.

Now with the prospects of improving demand and the reversal of the interest rate environment, banks will not have to tap into the fund that they will set aside for covering bad loans. This will also help them shield their business against downturns.

The impending interest rate hike (most likely later this month) should be a major catalyst to many aspects of the banking business. In fact, the Fed liftoff has the potential to take U.S. bank stocks to new heights.

With the change in the interest rate environment, banks will see easing pressure on net interest margins and stepped-up mortgage activity. But one should not expect a transformation overnight, as it will take some time for the rates to return to their pre-recession levels.

However, with the gradual rise in rates, banks will earn incrementally form the money they need to keep at the Fed. This is because short-term rates on that money will rise.

The biggest benefit is likely to be in the interest rate spread. While lending rates will improve in a higher interest rate environment, banks will not have to raise deposit rates a lot higher to attract funds as they already have excess deposits.

We’re standing on the threshold of a new rate environment and speculations of its impact, though not immediate, are rife. Perhaps a look at what’s characterizing the industry now will help in understanding its prospects. So here are the industry’s key trends:  

Mortgage Business: With a low rate environment encouraging people to refinance home loans, the industry is seeing an uptick in mortgage activity. While there have been fewer avenues for fresh originations so far, a likely improvement in real estate lending (in particular the residential side) should lift origination volume. But the overall declining trend of outstanding mortgage loans might persist, as the rate of mortgage originations will take a decent time to beat the rate at which mortgage loans have been repaid or charged off.    

Trading Activity: Higher volatility induced by macro events should favor trading activities at U.S. banks. However, the impact of global growth worries on bond yields and currency exchange rates might significantly dampen the benefits. Overall, trading activity is likely to remain subdued, particularly given the cautious steps taken by investors amid uncertainties surrounding the global economy. Even if trading volumes expand, this will have little effect on revenues thanks to customers’ increased preference for electronic trading to save charges. 

While trading revenues don’t generally indicate a bank’s real performance given the unstable nature of this activity, it is a large component of non-interest revenues for some of the major banks including Citigroup Inc. (C - Analyst Report), JPMorgan Chase & Co. (JPM - Analyst Report) and Bank of America Corp. (BAC - Analyst Report).

Investment Banking: With M&A activities and IPOs working in their favor, the generation of advisory and underwriting revenues has not slowed down. While this trend is expected to continue for some time, the equities division might slip on cautious steps by investors amid global growth concerns. Overall, investment banking might not contribute significantly to total revenues in the quarters ahead.
 

Loan Volumes: Overall loan growth is expected to improve on greater demand for commercial and real estate loans. Backed by economic recovery, the areas of auto, credit cards and student lending should also lift the fortunes of banks.

Legal and Regulatory Costs: The results so far in 2015 reflect some respite from high legal costs, with the sharp sting of fines and penalties being cured by settlements. Yet, the banks will need some more time to free themselves from the clutches of their bad karma. 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.

Banks Mull Over Aggressive Steps

In 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 dodge top-line pressure. Balance sheet restoration and easing lending standards after complying with regulatory guidelines is the trend. Further, a favorable equity and asset market backdrop should secure stability.

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. Also, ensuring prudent underwriting standards is essential in lessening reserves amid declining asset quality.
   
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 for Banks-West is #72, Banks-Southeast is #96, Banks-Northeast is #99, Banks-Major Regional as well as Banks-Southwest is #102 and Banks-Midwest is #144. Considering the Zacks Industry Rank of the six banking industries, one could safely say that the outlook for the group is ‘Positive.’

Earnings Trend

All the S&P 500 companies in the ‘Banks-Major’ and ‘Banks & Thrifts’ industries, which are the medium-level (aka "M") components of the broader Finance sector, have reported Q3 results. For Banks-Major, the beat ratio (percentage of companies coming out with positive surprises) was 53.3% for earnings and 20% for revenues. Banks & Thrifts however depicted a relatively weaker performance with an earnings beat ratio of 25% and revenue beat ratio of 0%.

Earnings and revenue beat ratios for the broader Finance sector came in at 53.6% and 45.2%, respectively. The sector has witnessed a year-over-year earnings increase of 1.2% on 0.1% revenue growth. 

Banks-Major saw earnings improvement of 23.5% despite a 2.4% decline in revenues. Banks & Thrifts however witnessed an earnings decline of 11.8% despite revenue growth of 3%.

The broader Finance sector’s consensus earnings growth expectation for Q4 is 9.1%, but revenue is expected to decline 4.7%.

Bottom Line

The industry is not likely to return to its pre-recessionary glory anytime soon. U.S. banks are of course leveraging from their new strategic positions and an improving economic backdrop, but mushrooming concerns and increased competition are thwarting profitability.

What encourages us is that the banks are getting accustomed to increased legal and regulatory pressure and resorting to safer alternatives for higher returns. However, structural changes in the sector will continue to impair business expansion and investor confidence.