Financial Services: Our Take on U.S. Tax Reform and Bank Deregulation

• The financial-services sector is slightly overvalued, trading at a 2% premium to our fair value estimates.
• Banking deregulation in the U.S. still faces an uphill battle, but smaller banks would reap the majority of any benefit.
• In our view, U.S. tax reform is still more likely than not, but if it does not get through before midterm elections, the chances decrease.
• Singapore banks are recovering from oil- and gas-related losses, the real estate market is not likely to slow down in Hong Kong, and bank levies increase the burden on Australian banks.

U.S. Banking Regulation By Eric Compton We still believe that efforts to repeal or replace Dodd-Frank entirely will face significant hurdles, and we don't expect significant boosts to profitability in the near future. Although headlines of a bill passing through the House of Representatives sound hopeful, the current bill would have to undergo many changes before getting past the Senate. We also do not expect this regulatory review to affect moats.

In our view, the most likely positive impact for bank shareholders would be an eventual easing of capital return restrictions, which could make it easier for banks to increase dividends and buybacks, and run their businesses with moderately higher leverage. Rolling back regulation could also decrease compliance costs for some banks as thresholds are adjusted for stress tests like the Comprehensive Capital Analysis and Review, or CCAR, for example. These changes would probably provide a greater benefit to smaller banks rather than the largest institutions.

U.S. Tax Reform By Joshua Aguilar We still believe U.S. corporate tax reform is more likely than not. Republicans have the requisite votes to pass both houses of Congress until the next midterm elections. Also, in the highly unlikely event that President Donald Trump would either resign or be forced out of office before the midterms, Vice President Mike Pence would take his place and likely continue similar tax-reform efforts. If anything, there's a slightly higher probability of tax reform under Pence given the issue's continued central importance to the Republican platform and his legislative experience.

Our calculus of tax reform passing would change with the passage of time and the Republicans' failure to pass reform before campaigning for the midterm elections is fully underway. On average, we would anticipate a modest 3% to 7% increase in our fair value estimates as a result of incorporating U.S. tax reform into our valuation models.

Singapore and Hong Kong Banks By Michael Wu The three Singaporean banks we cover rallied strongly in the second quarter as the deterioration of nonperforming loans to the oil and gas sector showed signs of stability in the first quarter. This was a key concern for the banks in the past two years, as a decline in oil prices pressured the oil- and gas-services sector, resulting in rising nonperforming loans. Our thesis on the three banks has largely played out, as we believe the downside from the oil- and gas-services sector was factored into their share prices last year. The banks are currently trading between 0.88 times and 0.97 times price/fair value and only slightly undervalued.

The Hong Kong Monetary Authority rolled out its eighth round of prudential measures for the residential property market. Not only has HKMA tightened the debt-services ratio and loan/value ratios for mortgages as per previous rounds of measures, the regulator also lifted the risk-weights used by banks to calculate regulatory required capital for new residential mortgages. The banks have responded to the higher cost of capital by increasing mortgage rates, and we believe the measures should alleviate the fierce competitive pressure in the mortgage markets.

In our view, the measures are unlikely to dent record increases in the residential property market as borrowers are able to finance mortgages through the financing arms of developers, which are not subjected to the HKMA prudential measures. As noted in a special report last year, we do not believe the Hong Kong banks are at risk if residential property prices decline, as the loan/values for their mortgage books are conservative, ranging from 60% to 70%. With the Hong Kong dollar fixed against the U.S. dollar, HKMA has lifted its base rate in line with the U.S. Federal Reserve's interest-rate increase. Our forecast for a slight increase in net interest margin in 2017 is unchanged, and the benefit of the interest-rate increase is factored into the share price of Hong Kong banks.

Australian Banks By David Ellis The four wide-moat-rated major Australian banks have individually quantified the estimated cost of the 2017 Federal Budget bank deficit repair levy, with the collective cost expected to be approximately AUD 965 million per year after tax. The collective pretax cost of the bank levy is estimated at AUD 1.38 billion per year, but all banks stressed significant uncertainty surrounding the calculation and the likely impact of the tax, as the proposed legislation is yet to be finalized.

We believe the introduction of the bank levy is a bad outcome for the major banks, customers, staff, and the broader economy. The revenue raised from the tax may address a budget deficit issue, but it sets a dangerous precedent. The Federal Treasurer has stated the bank levy is permanent. The bank levy is expected to be implemented on July 1, 2017, and applies to the four major banks and Macquarie Group. We remain confident that the four major banks can recoup most of the levy via pricing power over customers, improving productivity, and lowering cost bases.

Top Picks

Capital One Financial

COF

Star Rating: 4 Stars

Economic Moat: Narrow

Fair Value Estimate: $102.00

Fair Value Uncertainty: Medium

5-Star Price: $71.40

We believe rising charge-offs at narrow-moat Capital One have created another investment opportunity in what we regard as one of the best-managed banks we cover. While rising charge-offs have caused a sell-off in the stock, we view it as an expected normalization of credit losses and simply the result of Capital One's growth strategy. The stock currently trades below book value, which we view as too cheap.

Wells Fargo

WFC

Star Rating: 4 Stars

Economic Moat: Wide

Fair Value Estimate: $67.00

Fair Value Uncertainty: Medium

Consider Buying: $46.90

We believe the recent controversies surrounding U.S. bank Wells Fargo have created a buying opportunity. The company is already showing some signs of stabilization. Total branch interactions were down only 4% from March 2016, and account closures actually declined from the year-ago period. Average deposit balances--the key source of Wells Fargo's competitive advantage--expanded at a healthy rate for its most recent quarterly earnings. We believe the bank will more than recover from the issues of 2016.

T. Rowe Price Group

TROW

Star Rating: 4 Stars

Economic Moat: Wide

Fair Value Estimate: $88.00

Fair Value Uncertainty: Medium

While the active management industry is under assault for poor investment performance and high fees, wide-moat T. Rowe is the best-positioned among the 100 largest asset management firms (which account for 95% of the open-end fund and ETF AUM that Morningstar tracks). The biggest differentiators for T. Rowe Price are its scale, the stickiness of its asset base, strong brand identity, consistently solid long-term investment performance, and reasonable fees. While the growth from the revenue derived from its defined-contribution business will face headwinds from baby boomer rollovers, we think T. Rowe still has a compelling argument to retain more of this business than the market acknowledges. We believe T. Rowe deserves a premium valuation among its peer group.

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