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Zacks Industry Outlook Highlights: Citigroup and JPMorgan Chase

For Immediate Release

Chicago, IL – April 05, 2016 – Today, Zacks Equity Research discusses the U.S. Banks, (Part 1), including Citigroup Inc. (C) and JPMorgan Chase & Co. (JPM).

Industry: U.S. Banks, Part 1

Link: http://www.zacks.com/commentary/77103/us-banks-stock-outlook...

It is being assumed that U.S. banks will rally, as a tradition, when the Fed finally starts raising interest rates. But the linear relationship might not hold true this time around.

Despite consistent earnings performances over the past several quarters as well as the entry into the rate hike cycle, U.S. banks have not been able to draw investors’ attention, as evident by the poor performance of the KBW Nasdaq Bank Index (BKX) so far in 2016. The index, which typically thrives in a rising rate environment, has been underperforming the S&P 500 despite a rate hike in December and the possibility of a sequence of hikes (at least two this year). This indicates that investors are not hopeful about the sector’s ability to capitalize on this opportunity. But why?

Cheap money for a prolonged period and the resultant deflationary pressure, slump in crude oil prices, collapse of commodity prices and global economic threats may have altered the traditional relationship between bank stocks and interest rates.

Though banks might fail to keep the tradition of rallying into a new rate hike cycle this time around, their performance may not be as bad as it was during the drawn-out low-rate environment.

Rising interest rates will not only lift banks’ bottom lines through spread expansion, but will also help them earn incrementally from the money they need to keep at the Fed.

Further, supportive macroeconomic elements will minimize default rates on loans. Banks will also see increased demand for mortgage loans, car loans and other consumer loans with improving economic conditions.

However, the industry’s success trail since the last financial crisis hasn’t been consistent due to the nonstop cropping up of issues. And banks are not expected to be relieved of them any time soon. 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 their financials and will continue doing so. But a sharper focus on reducing needless expenses by reorganizing business, and an increased focus on revenues to boost bottom line are gradually making the growth path steadier.

Further, the benefit from reserve releases is gradually fading with a significant run down of reserves for the majority of banks. Banks had to resort to reserve releases in the last several years in order to offset the effects of weak demand and an ultra-low interest rate environment. But with the prospects of improving demand and rate hike cycle, banks will not have to tap into the fund that they set aside for covering bad loans. This will help them to shield their business against downturns.

We’re standing on the threshold of a new rate hike cycle, and speculation of its impact – though not immediate – is rife. Perhaps a look at what’s characterizing the industry now will help in understanding its prospects. So here are the industry’s key trends:

Mortgage Business: The past few years were tough for banks’ mortgage business due to a strict regulatory environment. While a low-rate environment encouraged people to refinance home loans, commercial banks witnessed sharply declining fresh originations. Further, low margin on fresh mortgages due to low rates and a rise in nonbank lenders made mortgage business miserable.

However, with the imminent rate hike cycle, significantly low unemployment rate and continued improvement in the housing market, the mortgage rate and fresh origination volume should rise.

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.

The Mortgage Bankers Association expects a 10% year-over-year increase in purchase originations to $905 billion and a one-third decline in refinance originations to $415 billion in 2016. Net originations are expected to decline 9% in 2016 to $1.32 trillion and 1% in 2017 to $1.31 trillion.

Trading Activity: Trading activity is likely to remain subdued, particularly given the cautious steps taken by investors amid uncertainties in the global economy. Some of the major U.S. banks – including Citigroup Inc. (C) and JPMorgan Chase & Co. (JPM) – have already hinted at dismal trading activities (particularly fixed-income and equity trading) in the first quarter, which is typically a strong quarter for the industry. This is because, low interest rates, volatile stock markets and plunging commodity prices kept customers away.

Investment Banking: According to Dealogic, global investment-banking revenue plummeted 36% year over year in the first quarter of 2016 to $12.8 billion – the lowest quarterly number since the height of the financial crisis. This indicates significant weakness in the U.S. investment banking segment, as five U.S. mega banks hold the majority of the global investment banking market share in terms of revenues.

As investors preferred to stay away from risky assets in the wake of the global rout, demand for IPOs and high-yield bonds reduced. As a result, revenues from advisory and underwriting slowed down. The equities division might continue to slip on a cautious stance by investors until global growth concerns slacken. Overall, investment banking might not contribute significantly to total revenues in the quarters ahead.

Loan Volumes: An improving labor market, a lower unemployment rate and a recovering housing market should support loan growth in the commercial and real estate space. Backed by economic recovery, the areas of auto, credit cards and student lending should also lift the fortunes of banks.

Legal and Regulatory Costs: The results for the last few quarters show some respite from high legal costs, with the sharp sting of fines and penalties being cured by settlements. Yet U.S. banks will need some more time to free themselves from the clutches of regulators for their wrongdoings. Plus, 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 targeted M&A deals may keep increasing.

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