Foreign Banks Stock Outlook - June 2015 - Zacks Analyst Interviews

The global economy proved its resilience once again in recent months after a cruel start to the year. While it can be safely said that growth remains moderate – actually a good reason for foreign banks to cheer – the prospects look uneven across the countries.

The International Monetary Fund's April update of the World Economic Outlook reveals its optimism on the future of the advanced economies and pessimism surrounding the growth prospects of the emerging nations. The Fund projected 3.5% growth for the world economy in 2015, is in line with its January forecast.

While the recently released biannual Global Economic Prospects report by the World Bank looks a lot glummer with a mere 2.8% growth projection for the world economy in 2015 (versus 3% forecast in January), it echoes IMF's concerns pertaining to the emerging world. Kaushik Basu, the World Bank's chief economist said, "We are advising nations, especially emerging economies, to fasten their seat belts."

Lower commodity prices, which is a result of a significant drop in oil prices since last year, will eventually lead to global growth. But the looming interest rates hike in the U.S. would make borrowing costlier for other economies. This, coupled with the strengthening of the dollar, will put a check on the growth of the global economy.

The performance of Eurozone is still not impressive with continued uncertainty stemming from the Greece conundrum, but the overall economy is finally shaping up. This has been possible partly because of improved equity and bond markets on the back of the quantitative easing, which began in March. In addition to this, lower oil prices and better credit market conditions were major drivers. The IMF has upgraded its growth forecast for the zone by 0.3%.

The second largest economy China is still slowing, but the government has been taking more aggressive steps to stabilize growth. The primary focus of the government has been to ease monetary strictness in order to boost credit activity and prevent devaluation of the property market.     

Japan is showing signs of recovery, though feeble, banking again on a loose monetary policy.

Russia is still troubled by Western sanctions and declining oil prices. While the government is trying to lessen the country's dependence on the West by extending its relationship with China, huge external corporate debt, declining foreign currency reserves and a high inflation rate should keep the Russian economy in troubled water for some time. According to the IMF, Russia is the worst performing among the big economies and could witness a deep recession this year.

Among the emerging markets, India is showing fast growth with the help of investor optimism on government efforts, but Brazil still bears the risk of recession with its tight monetary policy and high inflation. The latest World Bank report predicts India growing at a rate of 7.5% (versus 6.4% forecast earlier) -- the fastest among the major economies. 

A dramatic drop in oil process has given the global economy a new lease life. In fact, the consequent growth in income of the oil importing countries should contribute to the global output. However, the overall benefit will significantly depend on whether the weak oil price is a result of global demand weakness or just a consequence of excess supply.

Central banks of the developed nations (except U.S.) – particularly in Europe and Japan – are expected to keep the monetary policy loose for a longer stretch to support their economies. This should shore up the overall economy as well.

While growth driven by low oil prices will definitely support global banks with spurred business gains, a low interest rate environment as a result of the loose monetary policy will continue to mar the rate-sensitive portion of their revenues.

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

Further, the expected interest rate increase in the U.S. will lead to a capital flight for the emerging markets.  

These aside, a fiscal policy gridlock and the ever-increasing regulatory restrictions might soften the industry's upturn.

Nonetheless, the proactive defensive steps taken by the central banks of most developed and emerging economies will continue to keep non-U.S. banks afloat in the near term. But the weakness in the global financial system will keep the backdrop cluttered.

Non-U.S. banks keep repositioning business fundamentals to guard against further crises. Though defensive actions like limiting expenses are still in place and the focus on noninterest income is deepening, margin compression and slothful loan growth are serious dampeners.

Capital efficiency remains the key to survival, and most foreign banks have adopted reconstruction-by-asset-sale strategies to strengthen their capital ratios. While this will make their business safer, growth prospects appear bleak with thinning sources of income.

The interest rate environment in developed nations, save the U.S., is expected to remain low for some time. Naturally, revenues from interest income for banks in these regions are also unlikely to get a boost. 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 nagging non-interest revenue challenges. In fact, the expected capital outflow from these economies after the interest rate increase in the U.S. and due to the strengthening of dollar will add to their woes. Also, intense competition from domestic and foreign players will continue to hinder revenue generation.

Negative repercussions of the interest rate hike in the U.S. and the consequent elevation of funding insufficiency in the other economies, the not-so-effective cost-control measures, and limited access to revenue sources will keep bottom-line improvement under pressure in the upcoming quarters.

Moreover, the impact of tighter regulations is yet to be fully felt with many rules pending implementation across jurisdictions. Continued attempts by regulators worldwide to agree on strict capital standards so as to clip the risk-taking attitude of banks and prevent the recurrence of a global financial crisis will restrain the growth potential of the industry players.

The full implementation of the Basel III standards – the risk-proof capital standard agreed upon by regulators across the world – is due in 2018. Though the majority of non-U.S. banks have already started complying with the requirements, some are yet to make headway.

In addition to maintaining higher capital levels, global banks might see some new regulations down the road, given the proactive approach of regulators in seeking ways to keep a check on arbitration, overdraft and debt collection issues.

Further, as the number of banks struggling with data breaches is on the rise, lawmakers are likely to come up with rules for banks to spend more on bolstering the protection of their payment systems.

In any case, banks need to strengthen their compliance departments to tackle any pressure ahead of time.

Accumulating larger capital buffers over the cycle and reducing pointless complexity in business will be crucial to the performance of non-U.S. banks. Though cost reduction by job cuts and asset sales have been a key instrument to stay afloat, these strategies may no longer be enough.  Instead, the aim should be to enhance operational efficiency through fundamental changes in business models.

On the other hand, policymakers should primarily pay attention to determining the span of the fiscal stimulus, ensuring that it stays until a clear sign of transition from recovery to growth is visible.

Given the concerns surrounding the foreign banking space, it would be prudent to stay away from industry players that have not been able to win analysts' confidence with their activities. The following stocks have been witnessing downward estimate revisions and thus carry an unfavorable Zacks Rank:

Currently, Zacks Rank #5 (Strong Sell) stocks in our foreign bank universe are CorpBanca

and Standard Chartered PLC (SCBFF).

Zacks Rank #4 (Sell) stocks from the same universe include Westpac Banking Corporation

, ICICI Bank Ltd.

, HDFC Bank Ltd.

and National Australia Bank Limited (NABZY).

The industry might not be able to tide over the economic quagmire any time soon, but this is perhaps the right time for long-term investors to build positions in fundamentally strong foreign banks offering heavy discount now. Here are a few stocks that have been witnessing positive estimate revisions and carry a favorable Zacks Rank:

Currently, our foreign bank universe includes Zacks Rank #1 (Strong Buy) stocks like BBVA Banco Francés S.A.

, HSBC Holdings plc (HSBC), UBS Group AG

and Sumitomo Mitsui Financial Group, Inc.

.

The stocks carrying Zacks Rank #2 (Buy) include Barclays PLC

, Credit Suisse Group AG

, KB Financial Group, Inc.

and Lloyds Banking Group plc

.

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