U.S. Banks Stock Outlook - August 2015 - Zacks Analyst Interviews

Back-to-back thriving quarters and prospects of a favorable economy place U.S. banks near the trajectory of consistent growth. Albeit an impressive post-crisis journey, the industry's success trail hasn't been consistent, with new challenges often dragging on its players' performances.

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. But sharper focus on reducing needless expenses by reorganizing business and a greater role of revenues in boosting the bottom line are gradually making the growth path steadier.

Another catalyst is the impending interest rate hike, which might bring further stability to top-line generation. With the change in the interest rate environment, banks will see easing pressure on net interest margins and better mortgage activity. But this may not act as a significant support immediately because it will take some time for the rates to return to their pre-recession levels.

The biggest benefit is likely to be in the interest rate spread. While lending rates will improve in a higher interest rate environment, deposit rates will not rise much as banks already have excess deposits. Actually, they will not have to compete to maintain the required deposits.

Let's take a look at the key trends that the industry has been witnessing:

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 ), JPMorgan Chase & Co. ( JPM ) and Bank of America Corp. ( BAC ).

Investment Banking: With M&A activities and IPOs working in favor, the generation of advisory and underwriting revenues did not slow 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: While second-quarter 2015 results reflect some respite from high legal costs, banks will have to keep shelling out for their past wrongdoings for some time. However, the sharp sting of legal expenses seems to be gradually fading away with the settlement efforts by banks.

On the other hand, 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 and targeted M&A deals may keep increasing.

Banks Preparing to Go on Offense

Apart from defensive measures like expense controls, banks are working hard to play offense. Banks 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 pave the way for stability.

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

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

Prioritizing Growth: Banks are exploring new strategies to prioritize growth. Among others, banks are primarily focusing on cross-selling opportunities with the help of customer analytics. Also, ensuring prudent underwriting standards is essential in lessening reserves to account for 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 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 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 all the 250-plus industries in the 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry. (To learn more visit: About Zacks Industry Rank .)

As a guideline, the outlook for industries with Zacks Industry Rank of #88 and lower is 'Positive,' between #89 and #176 is 'Neutral' and #177 and higher is 'Negative.'

The Zacks Industry Rank for Banks-Major Regional is #50, Banks-Southeast is #53, Banks-Southwest and Banks-West is #71, Banks-Midwest is #83 and Banks-Northeast is #97. 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 S&P 500 companies in the 'Banks-Major' and 'Banks & Thrifts' industries, which are the medium-level (or M-level) components of the broader Finance sector, have reported Q2 results. For Banks-Major, the beat ratio (percentage of companies coming out with positive surprises) was 66.7% for earnings and 60% for revenues. Banks & Thrifts however depicted a relatively weaker performance with an earnings beat ratio of 60% and revenue beat ratio of 40%.

Earnings and revenue beat ratios for the broader Finance sector came in at 66.7% and 61.4%, respectively. The sector has so far witnessed a year-over-year earnings increase of 8.9% on 0.9% revenue growth.

Banks-Major saw earnings improvement of 11.6% despite 0.6% decline in revenues. Banks & Thrifts however witnessed an earnings decline of 1.6% despite revenue decline of 0.7%.

The broader Finance sector's consensus earnings growth expectation for Q2 is 10.4% compared with 16.5% year-over-year growth in Q1.

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

The Road Ahead

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

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.

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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.

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