Foreign Banks Stock Outlook - January 2017

The surprise Trump presidency and the Fed's rate hike, which revitalized U.S. bank stocks, actually spell trouble for the other economies and their banks. Also, there hasn't been any measurable progress on the global economic growth front that can translate to strength for foreign banks.

However, these haven't stopped foreign bank stocks from gaining some traction lately, as their success in reducing costs by realigning business and growing overall lending convinced investors. Moreover, slightly better economic growth helped them to enhance deposits and fortify asset quality, as consumers and businesses became relatively less levered.

This is clearly evident from the Zacks categorized Banks-Foreign industry's 20.2% gain over the past six months versus just 4.9% gain of the S&P 500.

Before we discuss how the prospects of foreign banks are shaping up, let's take a look at whether it's worth paying more premium for the stocks in the industry.

Do Foreign Bank Stocks Still Hold Upside Potential?

Yes, they do. While the 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 1.36 - the highest level seen in the last six months. When compared with its own average of 1.22 over that period, any further upside potential 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 3.36 and the median level is 3.28.

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. Though this 57-company industry has seen an 8% downward revision in earnings estimates in the recent past, it carries a Zacks Industry Rank of #83, which places it at the top 31% of the 265 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.

Expected Pickup in Economic Growth Might Alleviate Some Pressure

The World Bank sounded a little optimistic about global economic growth in 2017. In its Global Economic Prospects report released earlier this month, the bank predicted a rate of 2.7% versus 2.3% seen last year. This moderate pickup in growth is expected to stem from improvements in emerging markets and developing economies.

While a rise in interest rates in the U.S. and a strengthening dollar will lead to capital outflow and make credit expensive for emerging and developing economies, a recovery in prices for commodities like oil and metals, which many of these economies export, will help them to grow moderately. And this will spur banking activities in these economies.

In fact, the World Bank expects two large commodity exporting economies - Brazil and Russia - to see an end to the slowdown they have been witnessing for quite some time now.

On the other hand, though growth in the developed economies is expected to be slightly better than 2016, uncertainties created by Brexit, Trump's victory and the Fed rate hike will pose as hurdles on the path to progress. As a result, banks in these regions will struggle to show any improvement.

Bumpy Road Ahead for Banks in Key Nation

Shares of the major European banks, including Barclays (BCS), Deutsche Bank (DB) and Credit Suisse (CS), significantly underperformed their U.S. counterparts last year due to a dearth of business following negative rates and economic woes. The negative rates on deposits are forcing them to lend money to corporates and individuals, but this is not helping them in generating decent returns.

Moreover, the U.K. referendum to exit the European Union heightened their risks. Along with Brexit-induced uncertainties, bad assets on balance sheets and an unfavorable rate environment will hinder European banks from showing signs of improvement any time soon.

The prospects of the banks in Japan remain uncertain with the central bank leaving its interest rate unchanged at negative 0.1% at its Dec 2016 meeting. However, the central bank revised its views up on exports and output based on the yen's decline against the greenback. The economic growth is unlikely to materially benefit the country's banking system by offsetting the damage caused by the negative rate environment.

The aggressive negative interest rate backdrop already led to shrinking profits for Japan's top banks last year from April through September. The top three banks by assets -- Mitsubishi UFJ Financial Group, Inc. (MTU), Mizuho Financial Group, Inc. (MFG) and Sumitomo Mitsui Financial Group, Inc. (SMFG) -- witnessed respectively 18%, 7% and 7.5% declines in net profit during that period.

The latest hike in interest rates in the U.S. will create growth headwinds for China due to significant capital outflow from the economy. Moreover, after a number of rate cuts in an effort to stimulate the economy, the benchmark rate in China currently stands at 4.35%, which is not unfavorable for its banks.

However, the nation's banks may not get any further support on the rate front as the central bank may not be able to raise rates any time soon. On the other hand, the economy's credit vulnerability could be dangerous for its banking system.

Weak Macro Backdrop to Continue Curbing Growth

A slight pickup in economic growth will definitely support foreign banks with business gains. But the continuation of loose monetary policy - needed to revitalize growth in the developed economies - will mar the rate-sensitive portion of their revenues.

On the other hand, any action to lower interest rates in emerging markets (like Brazil) that have a tight monetary policy could aggravate inflation issues. This, in turn, would take a toll on their banks.

Business Realignment Yet to Override a Weak Backdrop

Foreign banks keep repositioning business fundamentals to protect themselves from further crises. Defensive actions like limiting expenses by contracting operations and retrenching workforce are still in place, and the focus on noninterest income is extending. But sluggish business activity due to lack of steady economic growth, margin compression and sluggish loan growth remain serious dampeners.

Capital efficiency remains the key to survival, and most foreign banks have been strengthening their capital ratios by selling non-core assets for quite some time. Further, banks will continue to improve solvency and balance sheet liquidity as they move closer to comply with the Basel III requirements. While this will make their businesses safer, growth prospects look dull with limited flexibility to invest in new ventures.

Revenues Sources Yet to Be Dependable

The interest rate environment in developed nations (except the U.S.) is not expected to revive any time soon. Naturally, interest-sensitive revenues for banks in these regions are likely to remain under pressure. At the same time, their non-interest revenue sources will be limited by regulatory restrictions.

Banks in consumption-driven economies, however, may not be significantly challenged by interest income due to a not-too-low interest rate environment which is needed to keep inflation at check.

However, these banks will have no respite from the nagging non-interest revenue challenges. Further, the expected capital outflows from these economies with rising interest rates in the U.S. will add to their woes. Also, intense competition from domestic and foreign players will continue to hinder revenue generation.

Further, under President Trump, foreign banks that have significant operations in the U.S. might face stricter supervision. This will curb their benefits from the prospering U.S. economy.

Localization of Banking

Tight regulation is gradually making globalization of banking a thing of the past. Global banks have been curtailing their exposure to certain countries since the financial crisis due to lack of efficiency and reduced profitability following stringent regulation.

Particularly, stricter capital and liquidity requirements, and segregation of business lines based on the needs of respective countries, are hurting foreign banking operations in many economies.

Bottom Line

The rate-hike stance of the Fed is posing near-term concerns related to funding crunch in other economies and their banks will bear the brunt. Moreover, limited access to revenue sources will restrict bottom-line improvement of foreign banks. But the effectiveness of cost-control measures and growing overall lending supported by moderate economic recovery might lead to some improvement in their financials in the upcoming quarters.

Cost reductions by job cuts and asset sales will be instrumental in keeping foreign banks afloat, but these strategies will not long be sufficient to counter the tough backdrop. Instead, the aim should be to enhance operational efficiency through fundamental changes in business models.

Foreign Bank Stocks Worth Buying Now

The industry might not be able to tide over the economic mayhem anytime soon, but considering the current valuation, it's actually time to pick a few stocks from this space. Here are a few stocks that have been witnessing positive estimate revisions and carry a Zacks Rank #1 (Strong Buy):

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

Bank of Montreal (BMO): The stock has gained over 46% over the last year. Earnings estimates for the current fiscal year were revised 4.8% upward over the last 60 days. Also, the stock surpassed estimates by an average 6.4% over the trailing four quarters.

The Bank of N.T. Butterfield & Son Ltd. (NTB): The stock has seen 26.6% upward revision in earnings estimates for the current fiscal year over the last 30 days. Also, the company delivered an average positive earnings surprise of 22.5% over the trailing four quarters. The stock has gained over 37% since mid-September last year.

KB Financial Group Inc. (KB): The stock has gained nearly 60% over the last year. It has seen earnings estimates for the current fiscal year revising 24.4% upward over the last 30 days.

Zacks' Top Investment Ideas for Long-Term Profit

How would you like to see our best recommendations to help you find today's most promising long-term stocks? Starting now, you can look inside our portfolios featuring stocks under $10, income stocks, value investments and more. These picks, which have double and triple-digit profit potential, are rarely available to the public. But you can see them now. Click here >>

Want the latest recommendations from Zacks Investment Research? Today, you can download 7 Best Stocks for the Next 30 Days. Click to get this free report

Sumitomo Mitsui Financial Group Inc (SMFG): Free Stock Analysis Report

Bank of N.T. Butterfield & Son Limited (The) (NTB): Free Stock Analysis Report

Mitsubishi UFJ Financial Group Inc (MTU): Free Stock Analysis Report

Mizuho Financial Group, Inc. (MFG): Free Stock Analysis Report

KB Financial Group Inc (KB): Free Stock Analysis Report

Deutsche Bank AG (DB): Free Stock Analysis Report

Credit Suisse Group (CS): Free Stock Analysis Report

Bank Of Montreal (BMO): Free Stock Analysis Report

Barclays PLC (BCS): Free Stock Analysis Report

To read this article on Zacks.com click here.

Zacks Investment Research

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

More Related Articles

Sign up for Smart Investing to get the latest news, strategies and tips to help you invest smarter.