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US bank stocks set for worst year since 2011

U.S. bank stocks are on pace to see their worst annual returns since 2011, a drop-off that analysts believe will likely seep into the new year.

As of Dec. 27, the SNL U.S. Bank and Thrift Index had plunged 19.8% in 2018, the benchmark's largest decline in seven years. By comparison, the S&P 500 fell 7.7% in 2018.

"Universal bank stocks underperformed the broader market this year as loan growth repeatedly disappointed and macroeconomic risks weighed on shares into year end," Keefe Bruyette & Woods analysts Brian Kleinhanzl and Michael Brown wrote in a Dec. 11 research report. "As we look to 2019, we do not see enough positive catalysts emerging — besides the group simply having a discounted valuation — that could move the group higher."

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Banks were widely expected to see high stock returns heading into 2018. Financial institutions as a whole were projected to see massive windfalls from the overhauled tax code championed by President Donald Trump's administration, which passed in December 2017. At the same time, Trump's administration has spearheaded a campaign to roll back financial regulations, an effort that led to a proposal that would loosen trading and investing restrictions for some banks earlier in 2018.

Yet, the second half of 2018 has proven difficult for bank stocks. The SNL U.S. Bank and Thrift Index slid 17.6% from July 2 to Dec. 27, while the S&P 500 dropped 8.7%. Much of the loss came in the fourth quarter alone, thanks in part to the wild market swings that have caught investors off guard in recent weeks.

Rising interest rates became a double-edged sword for banks halfway through the year, as deposit costs began to creep upward and the changing betas eroded margins. The total cost of funds for the U.S. banking industry reached 86 basis points in the third quarter, up from 75 basis points and 63 basis points in the second and first quarters, respectively.

Investors sold off banks that notched surprising deposit cost increases, including Bank OZK. The stock experienced a dramatic sell-off after the company reported that interest-bearing deposits increased 21 basis points in the second quarter and its spread declined seven basis points. Investors continued pressuring shares following third-quarter credit issues stemming from the bank's real estate specialties group portfolio, which has been a source of concern for the company's critics.

Puerto Rico-based banks did provide the industry a bright spot in 2018, though. OFG Bancorp, First BanCorp. and Popular Inc. saw three of the four largest share-price gains in 2018, despite lingering concerns over Puerto Rico's debt crisis and Hurricane Maria, which decimated much of the island's infrastructure.

Throughout the year though, the three banks have cut their exposures to Puerto Rico's debt, while relief funds for the island have stood its economy back up as it continues to recover from Maria.

As for 2019, analysts remain cautious. KBW's Kleinhanzl and Brown wrote that fears regarding the Federal Reserve raising interest rates "too aggressively" and trade wars, on top of a slowdown in economic growth, will likely continue to weigh down stocks well into the new year.

"We believe we are moving to an extended risk-off environment and this will also be negative for universal banks, which are challenged to outperform during the last stages of an economic cycle," the analysts wrote.

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