Many Positive Trends but Few Compelling Valuations for Banks
Wells Fargo is still the standout in the sector.
Many of the U.S. banks we cover presented at the Barclays Global Financial Services Conference last week, giving updated takes on guidance and views on the industry and the U.S. economy.
Overall, not much changed, with only slight adjustments to guidance. Despite several positive industry trends, we don’t see many compelling valuations in the U.S. banking sector. Wells Fargo (WFC) is the main standout, trading at a 23% discount to our fair value estimate. Many of the regional banks we cover, despite our assumption that a tax cut will take place, still trade at or even above our fair value estimates.
Several key themes emerged during the conference, including the consistency of low deposit betas, continued efforts to improve operating efficiency, increasing capital returns to shareholders, and marginally slower loan growth for the third quarter. The universal U.S. banks also mentioned a likely reduction in third-quarter trading revenue.
We believe investors should not overreact to these short-term declines in loan growth or trading revenue. As for trading, volatility may have remained low over the summer, but we don’t expect markets to remain calm forever. At the same time, a tight rein on expenses across the industry in recent years should pay off once volatility returns. For loan growth, once uncertainty abates surrounding key proposals in Washington, such as those related to tax reform, we believe commercial investment and mergers and acquisitions should pick up more.
Many of the banks were confident that low deposit betas would continue to hold, and even with slower loan growth, margins should remain steady to up. We believe that low betas cannot stay forever. Eventually competition will have to pick up. As a result, we forecast that betas will begin increasing in 2018 and net interest margin expansion will begin to slow somewhat, but will still occur amid slow but steady rate increases over the next several years.
While some of the banks will be affected by the destruction from the recent hurricanes, there was not much specific guidance around the effects of these storms. All affected banks commented that any costs should be manageable, and many losses will be covered by insurance.
Many of the banks remarked that they will also continue closing branches and investing in digital initiatives, leaving room for them to keep improving operating efficiency over the medium term. We project nearly all banks under our coverage improving their cost/income ratios over the next several years as this trend plays out.
Finally, the push toward lower common equity Tier 1 ratios remains a key theme as banks attempt to more efficiently use their capital, improve returns on tangible equity, and return excess capital to shareholders following excellent results from the Comprehensive Capital Analysis and Review. As an example, we expect undervalued Citigroup (C) to return 10% of its current market capitalization to shareholders in the form of dividends and repurchases over the next 12 months, with dividends likely to account for a larger share of that total over time. This more efficient capital base will be another key item helping U.S. banks to improve returns on equity over the medium term.
Eric Compton does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.