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UK banks have been largely overlooked and unloved by investors in recent years and perhaps for good reason.
Over the past decade the FTSE All-Share has delivered a total return of 99.6 per cent while the UK banking sector has eked out a paltry 17.5 per cent.
This dismal performance is in large part because of rock bottom interest rates and tight monetary policy since 2009.
Lacklustre: Rock-bottom interest rates and tight monetary policy have seen high street banks perform poorly in recent years
But the UK continues to have significant exposure to the financial sector – around 8 per cent of the market – so some investors may be reconsidering their aversion to high street lenders.
Will rising interest rates help buoy their share prices, or will the cost of living crisis dampen consumer confidence and their prospects for the year?
One of the biggest headwinds for the banking sector since 2009 has been rock bottom interest rates.
Banks usually make money by taking deposits and lending them back to borrowers at higher rates and for a longer time.
They can also take long-term, non-interest-bearing deposits and hedge them using interest rate swaps. These form a bank’s net interest margin (NIM) but they have been slashed in this prolonged period of low rates.
So will banks be cheering the Bank of England’s fourth rate hike in six months?
Bank of England Governor Andrew Bailey has warned of a massive downturn
‘Higher interest rates are good news for banks as it allows them to make a higher net interest margin,’ says James Yardley, senior research analyst at FundCalibre.
‘For years, very low interest rates have made this incredibly difficult. Even a small change can have a big impact on such a highly geared business.’
Before the Monetary Policy Committee’s decision to increase the base rate, Lloyds said it expected a NIM of 270 basis points, up from 250, and a return on tangible equity greater than 11 per cent this year.
Yardley adds: ‘The other thing banks have going for them is they are very unloved and often trade below or close to book value. This means you don’t have to see much of a positive change to see a huge improvement in stock prices.’
Challenger banks pose an existential threat
As well as grappling with high inflation and the prospect of another recession, banks are also having to deal with an increasingly saturated market.
‘There is a lot of competition between established players and also from fintech and digital-only rivals – and this is forcing the incumbent banks to invest heavily in IT and their service proposition, to the possible detriment of short-term earnings. The regulator continues to keep a close eye on the sector,’ says Mould.
The powerful challenger trio made up of Starling, Monzo and Revolut has quietly built up solid, and perhaps more importantly loyal, customer bases and securing lofty investments.
Starling, which has been profitable on a monthly basis since October 2020, recently completed a £130.5million fundraise ‘to build a war chest for acquisitions’.
The funding round gives a pre-money valuation of more than £2.5billion for the UK bank and founder Anne Boden has indicated the fintech is aiming to go public next year.
Mould says: ‘Customer loyalty was badly eroded by the financial crisis and banks are still not necessarily held in high esteem, which may explain why new market entrants can make ground, at least in terms of customer acquisition.
‘All of this makes achieving growth pretty hard, at least without taking risk by lending money to those who already have a lot of debt, or through investment banking, which can be great in boom times and very hard work during market downturns.
‘This may explain the dash toward wealth management and private banking, as customers are stickier and fees can gently accumulate, providing the customers feel they are getting a good service, the fees are not too high and nothing happens that jeopardises their wealth.’
But if interest rates continue to rise sharply it could cool mortgage markets and lead to a rise in bad loans among consumers ‘who will also be feeling the pinch from inflation and the sharp increase in the cost of living,’ says AJ Bell’s investment director Russ Mould.
‘Higher loan provisions could weigh heavily once more if the economy turns turtle under the weight of interest rate rises.’
Yardley adds: ‘The downside of higher rates is this could trigger problems in the housing market as we saw in 2007 and 2008. With house prices currently so high relative to incomes, the market is vulnerable if demand for homes collapses.
‘A collapse in house prices would be very bad news for banks. We’ve already seen banks start to position themselves for more mortgage defaults.’
While banks may have welcomed the recent rate hike they are unlikely to feel the same enthusiasm about its economic outlook.
The central bank issued a pessimistic forecast: it now expects inflation to peak as high as 10 per cent late this year, on the back of a further 40 per cent hike in energy prices in the autumn.
This, paired with the risk of a recession, is not a good prognosis and even with rising rates banks will suffer.
‘As the UK economy appears to slow… and inflation pushed to a 30-year high of 7 per cent in the 12 months to March with expectations of double digit figures this summer – this serves up a sour economic cocktail of soaring inflation, decelerating growth and increasing interest rates, which even the banking sector will find difficult to swallow’, says Alice Haine, personal finance analyst at Bestinvest.
‘Add in the fallout from the Ukraine-Russia war, such as eye-wateringly high energy prices, and it’s no wonder Britons are tightening their belts or being forced to borrow more to sustain their lifestyles – money that they may not be able to pay back as the situation worsens.’
Figures from the Bank of England show high street lenders expect a rise in the number of consumers struggling to repay credit cards and other loans as the cost of living crisis continues to bite.
Lloyds boss Charlie Nunn recently said the bank was contacting customers ‘where [it] feels they may need assistance and will continue to help with financial health checks and other means of support.’
He added: ‘Whilst we are seeing continued recovery from the coronavirus pandemic, the outlook for the UK economy remains uncertain, particularly with regards to the persistency and impact of higher inflation.’
Add in the fact Lloyd’s has increased its pot to cover bad loans by £177m and it is clear it is worried about a spike in defaults.
Sophie Lund-Yates, lead equity analyst at Hargreaves Lansdown adds: ‘Things are far from crisis levels, but a steep economic downturn would hurt all banks’.
Cash-strapped: Britons are tightening their belts or being forced to borrow more to cover their outgoings, which might mean banks need to spend more on covering defaults
The headwinds that have affected the sector since the financial crisis are likely to hang over them throughout this year and into the next.
It might mean that banks continue to be an unloved sector for investors, but Mould suggests this may mean they are undervalued.
All five of the FTSE 100-listed banks trade at a discount to net asset value per share.
‘On the face of it, all five also pass regulatory capital requirements with ease, given lofty CET1 ratios and relatively lowly leverage ratios, so they have, in that respect weathered the pandemic pretty well,’ Mould says. ‘Especially as they spent much of 2021 writing back the bad loan provisions they took in 2020 because their worst case scenario did not materialise.’
If you think bank stocks are unfairly unloved and undervalued, there are plenty of opportunities to gain exposure to the sector.
The good news is banks are cheap. The bad news is they may deserve to be, especially if the economy turns down
AJ Bell’s investment director Russ Mould
Haine says: ‘Banks are well represented on the UK stock market, comprising 8 per cent of the market, so a simple tracker like the Fidelity Index UK fund will provide exposure.’
She also points to TM Redwheel UK Equity Income, managed by Ian Lance and Nick Purves, which targets undervalued companies.
‘Since December last year when the BoE increased rates for the first time since the start of the pandemic, bank share prices are now slightly ahead of the wider marker – albeit they sold off aggressively in mid to late February before recovering,’ Haine says.
‘How they will perform over the course of 2022 will depend on how well they handle the economic challenges ahead.’
Yardley points to Polar Capital Financials Trust and Jupiter Financial Opportunities, which have returned 54.9 per cent and 27.41 per cent respectively over two years but ‘have suffered in the past few months along with the wider market’.
Mould adds: ‘The good news is banks are cheap. The bad news is they may deserve to be, especially if the economy turns down, but a gently inflationary recovery with gently rising interest rates and stock markets that perform solidly would be a boon.
‘Whether central banks can engineer such a dreamily soft landing remains to be seen.’
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