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Investment & Strategy

US Large-Cap Banks – To be or not to be invested!

The above phrase is likely to evoke memories of the famous soliloquy by Prince Hamlet in William Shakespeare’s play Hamlet, but at the current juncture it is a relevant question for investors holding US large-cap banks. Given the sharp rally in this space in a short span of time (average return of ~23% after the result of the US presidential elections on 8 November 2016) investors are pondering whether to stay invested or exit their holdings.

In our view, the recent surge in the stock prices of US large-cap banks could lead to a short-term pullback or minor consolidation phase, but the building blocks of a sustained rally in the segment remain intact. Having said that, we would like to caution investors that the recent rally has already factored in the benefits of the low-hanging fruits with the 25-bps increase in Fed funds rate in December and the spike in long-term bond yields in the US. The road ahead in 2017 is likely to be volatile as the sustenance of the upward momentum is predicated on a host of factors.

Investor sentiment on US large-cap banks has undergone a sea change after the US presidential elections, with the victory of a pro-business leader and the Republicans gaining majority in both houses of the Congress. The US economy appears to be in a sweet spot, as this is the first time in six years that the federal government is well-positioned to stimulate the economy without facing much resistance. Trump’s proposals include providing fiscal stimulus through infrastructure spending of USD 1 trn and overhauling the tax system by cutting tax rates and changing the tax brackets. These measures are likely to boost economic growth in the US and provide a favourable backdrop for increase in interest rates by the US Federal Reserve. Further, the Trump administration has indicated that it aims to reduce the regulatory burden for the US banking sector through possibly (1) a change in the leadership at key regulatory bodies, (2) amendment of parts of the Dodd–Frank Act and/or (3) an easing of the supervisory oversight and process (stress test or the Comprehensive Capital Analysis and Review exercise). We believe that the materialisation of these factors would underpin positive earnings revision and healthy capital returns for US large-cap banks.

In 2017, US banks are likely to benefit from (1) an expansion in net interest margins due to higher interest rates and steepening of the yield curve (the Fed expects three rate hikes in 2017), (2) increased loan demand, and in turn, healthy loan growth (mainly in the consumer, and commercial and industrial loan segments) due to expectations of a stronger US economy, (3) the ongoing favourable backdrop for capital market activity (in particular, M&A and equity capital markets activity, rising rates/volatility and improving competitive environment due to retrenchment of European players), (4) a benign credit environment and (5) solid capital-return potential as reduced regulations would lead to higher payout ratios.

We prefer US large-cap banks as they are more leveraged to the listed benefits. Among the large-caps, we like Citigroup owing to its attractive valuation, continued focus on cost control, credit discipline and improving profitability, and its strong shareholder return potential.

 

Author
Shekhar Kedia

Equity Expert

Data & recommendations as of January 09th, 2017 close

This document is an objective and independent explanation of the content of the recommendation and cannot be considered as adapted to a person or based on the analysis of the situation of a person.