Bank Stocks Extend Their Winning Streak

Washington extended a helping hand to banks in 2017, pushing stocks in the sector higher for a second year in a row.

President Donald Trump's election in late 2016 prompted a surge in bank stocks on hopes that a tax overhaul and deregulation would help profits. Now, the tax and regulatory changes are finally happening, and they are proving a potent antidote to persistently low long-term interest rates, subdued trading activity and slowing loan growth.

Investors have grown increasingly confident banks' bottom lines will be huge beneficiaries of a lower tax rate. The KBW Nasdaq Bank index rose 16% in 2017. Although shy of the 19% gain for the S&P 500 this year, the advance puts the bank index's total increase since the 2016 presidential election at 42%. Nearly all of the 2017 bank gains occurred in the last four months of the year when new tax legislation gained steam.

"Investors were first concerned, and then got enthused over rates, revenues and regulation," said Mike Mayo, a bank analyst at Wells Fargo & Co.

For much of 2017, bank shares struggled to build on their postelection gains. The passage of tax-code changes seemed questionable after health-care legislation efforts failed and stubbornly low long-term interest rates continued to weigh on profits. But investors became more optimistic when tax-overhaul efforts started to seem more likely in the fall.

Banks in the U.S. tend to pay relatively high tax rates, so they are expected to benefit from the planned cut in the corporate rate. Goldman Sachs Group Inc. analysts estimated in December that the measures, which include a 21% corporate tax rate, would boost large bank earnings by about 13% in 2018.

Bank executives said they expect additional benefits from the plan. The tax changes will be "good for the economy, good for job creation and wage growth and all good things will come from that," JPMorgan Chase & Co. Chief Financial Officer Marianne Lake said in December. Many big banks, however, will first have to take a one-time hit to earnings from the changes.

Also boosting banks is the arrival of new Trump administration appointees in Washington. Bankers were eager for an end to the tough regulatory scrutiny of the Obama era, which led to higher compliance costs and major fines.

In recent months, regulators have started to grant banks a number of the changes they have long sought, opening the door to giving more details of annual Federal Reserve stress tests in advance and revising guidelines that limited some kinds of business lending.

Federal Reserve rate increases, which continued in mid-December, also helped profits by enabling banks to earn more on loans. Bank of America Corp., the second-largest in the U.S. by assets, in the third quarter posted its highest quarterly profit in six years. Analysts predict the bank will post annual profit records in 2018 and 2019.

Now, the question is whether bank stocks can sustain gains for a third year in a row and regain the record level they set before the financial crisis. Since a slight decline in 2015, the KBW Nasdaq Bank Index has rallied to within 12% of its record from February 2007. But challenging trading, lending and interest-rate conditions could stop the index from reclaiming that level in 2018.

Bank of America, Citigroup Inc. and JPMorgan have all said they expect trading revenue to fall in the fourth quarter due to low volatility.

Another difficulty is the slowing pace of loan growth. Loans grew 4.1% from a year earlier near the end of December, down from 7.3% before the election, according to the Federal Reserve. Growth for business loans has been particularly weak, despite the stronger economy.

And although banks have benefited from the Fed's tightening, which involves a key short-term interest rate, longer-term rates have remained low, threatening future profits. The difference, or spread, between 10-year and two-year U.S. Treasury debt, a rough proxy for bank profitability, stood at about 0.5 percentage point at the end of December, near its lowest level in a decade.

This "flattening" yield curve will become a bigger issue if banks feel more pressure to pay customers a higher rate on their deposits. If loan balances aren't growing briskly and the interest-rate spread is narrow, it is far tougher for banks to increase lending profits.

Barclays analyst Jason Goldberg projects that lending profit margins will rise next year, but not as much as they did in 2017.

The flatter yield curve, he says, "will matter at some point."

Write to Rachel Louise Ensign at rachel.ensign@wsj.com

(END) Dow Jones Newswires

December 30, 2017 07:14 ET (12:14 GMT)