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Here are Goldman’s favorite bank stocks for the rest of 2017

  • Goldman tells its clients to buy financial stocks, predicting the sector will outperform the market due to increasing shareholder dividends and stock buybacks.
  • Bank stocks have underperformed the market this year. The Financial Select Sector SPDR Fund rose 9.2 percent year to date through Friday compared to the S&P 500's 10.6 percent return.

Financials stocks are set to surge higher over the next 12 months due to rising dividends and bigger share buybacks, according to Goldman Sachs.

"We believe 2017 will mark an inflection point in the amount of capital the Fed allows financials firms to return to shareholders. … This is the first year that certain money center banks have been permitted to pay out more than net income," strategist David Kostin wrote in the note to clients Friday. "Accelerating dividend growth should attract equity income investors, who are broadly underweight the financials sector."

Goldman's analysts project the bank sector will increase its dividends by 17 percent annually during the next two years. In addition, Kostin noted how the recent positive Federal Reserve stress test results will enable financial companies to increase share buybacks by 45 percent this year.

Stock "repurchases will lift earnings per share, return on equity and share prices," he wrote.

On top of the capital returns, Goldman predicts interest rates will also rise and boost the sector's earnings prospects.

"Our economists forecast faster inflation and Fed tightening than the market expects," the strategist wrote.

Bank stocks have underperformed the market this year. The Financial Select Sector SPDR Fund rose 9.2 percent year to date through Friday compared with the S&P 500's 10.6 percent return.

"Recent client conversations have focused on the prospects for stocks in the financials sector, which we recommend as an overweight despite recent underperformance," Kostin wrote.

Here are three buy-rated financial stocks Goldman recommends with the firm's current price targets.

— CNBC's Michael Bloom contributed to this story.

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