US banks: Poised to benefit from cyclical upturn and structural tailwinds
After nearly a decade of challenging economic and operating conditions, US banks are back. Indeed, the median bank reported robust second-quarter operating earnings of 29% year-on-year growth1 on the back of higher revenues and lower taxes. US banks’ strong performance is the result of two key factors: a cyclical economic upturn coupled with structural tailwinds that may underpin the growth potential of US banks for the long run. Manulife Asset Management believes these catalysts uniquely position the sector as an attractive, long-term investment opportunity.
Cyclical upturn driven by strong US growth and rising interest rates
A strong US economic recovery led the Federal Reserve (Fed) to begin normalizing monetary policy by increasing the federal funds rate from a prolonged zero interest-rate level and unwinding its quantitative easing program.
Since December 2015 US Fed has raised the federal funds rate seven times to a range of 1.75%-2.00% (as of June 2018), resulting in a higher level of short-term interest rates in the US relative to Europe, Japan and other developed markets.
Although the Fed is poised to continue its rate normalisation path, the team believes that the absolute level of interest rates, from a historical perspective, remain low enough to have only a minimal impact on future loan growth.
Indeed, a stronger economic environment could lead to increased loan growth for the industry and a continuation of positive credit trends, as credit costs remain near cycle lows. It is expected that loan growth will accelerate in 2018 from the 3-4% range the industry experienced in 2017, supported by the potential for stronger economic growth and the passage of tax reform.
Structural tailwinds improve US banks’ profits and efficiency
Structural changes, including industry deregulation and tax reform, are also beneficial to the US banking sector.
In addition to the naming of regulatory agency heads in key positions favouring banking deregulation, the US Congress has moved forward to roll back certain provisions of the Dodd–Frank Wall Street Reform and Consumer Protection Act. One important revision was to raise the threshold for Systemically Important Financial Institutions (SIFI) from US$50 billion or more in total assets to US$250 billion.
Small regional banks would particularly benefit from this change, as they would no longer be subject to onerous annual stress tests, potentially lowering their compliance costs and increasing the likelihood of increased capital returns to shareholders.
As the regulatory environment continues to ease, Manulife Asset Management’s investment management team believes that banks should see more operating leverage through efficiency improvements due to a slowdown in the growth of, or an actual decline in, compliance costs for many banks. Investors may also benefit through higher capital returns in the form of dividend increases or additional share buybacks.
Regulatory easing could also lead to an increase in merger and acquisition (M&A) activities in the sector, a secular driver of returns that has been a key factor in reducing the number of banks in the country from roughly 18,000 in 1985 to 5,700 banks in 20172, ultimately improving the efficiency of the overall industry.
With the far-reaching tax reform passed by the US Congress late last year, the statutory corporate tax rate in the US has been reduced from 35% to 21%. The banking sector is well-positioned to benefit from lower tax rates as the industry pays, on average, a 30-33% effective tax rate.
As a result of tax cuts, according to Manulife Asset Management’s analysis, earnings of US banks may now grow, 25% in 2018 on average after factoring in tax reform (versus 10% without tax reform), along with an improved return on assets and return on equity.
In light of these structural tailwinds, the team believes that banking sector valuation levels remain historically attractive. As of June 2018, banks were trading at 1.49 times book value, well below their long-term average of 1.82 times3. Indeed, valuation levels are only marginally above those seen in 2014 when the operational environment was palpably different: a Fed funds rate near zero that led to compression of net interest margins (NIMs), and a more onerous regulatory environment.
US banks boast an advantageous position over international banks
US banks have historically offered investors a compelling return. For example, the sector outperformed all broad-based market indices over the 10-year period ended 1 June 20184. Most notably, it also outperformed international indices such as the MSCI Emerging Markets Index and MSCI World Financials Index by a wide margin.
The team considers that US banks are generally more attractive than many of their international competitors. The interest rate differential between the US and other developed countries is one reason why they are more constructive on US banks: as higher rates in the US have led to increasing NIMs - the difference between what a bank pays to get deposits and receives from lending- and higher net interest income.
When interest rates are declining, banks will typically lower both deposit rates and loan rates. However, in the prolonged low interest-rate environment following the financial crisis, loan rates went further down with interest rates- new loans thus become cheaper than earlier originated loans. This dynamic led to a decline in NIM, a trend that has gradually reversed as the Fed increased interest rates.
Finally, despite existing global trade tensions, US banks have remained resilient without a significant deterioration in credit or slowdown in lending. The sector’s second quarter earnings point to increased lending, benign credit conditions, and continued confidence in the US economy’s expansion despite increased market volatility due to trade tariffs.
US Banks: An Attractive Investment Opportunity
Overall, as the team concludes, tailwinds for the US banking sector—a better interest rate environment with rates rising in the US leading to increasing NIMs and higher net interest income, solid loan growth from improving economic activity, low levels of problem loans, high capital levels, sufficient liquidity, and return above banks’ cost of capital—provide a good backdrop. The structural changes of industry consolidation and an improving regulatory environment, along with benefits of US tax reform and valuations below long-term averages, creates a very attractive investment opportunity for US banks.
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Important information: Investment involves risk. Investors should not make investment decisions based on this material alone and should read the offering document for details, including the risk factors, charges and features of the product. This material has not been reviewed by the Securities and Futures Commission. Issued by Manulife Asset Management (Hong Kong) Limited.
1 Manulife Asset Management, July 2018
2 Federal Deposit Insurance Corporation, as of 31 December 2017
3 SNL Financial, 30 June 2018, in USD
4 Morningstar, as of 31 May 2018