If the global economy is indeed the central issue for the sector, then the case for buying does seem compelling. The IMF’s latest forecasts, published earlier this month, suggest that the UK economy will expand by 2.9 per cent this year - up from 1.8 per cent in 2013. Prospects are similarly healthy in the US, where the IMF expects economic growth of 2.8 per cent in 2014. Even the eurozone is on the mend. After contracting by 0.5 per cent last year, the IMF expects the region’s combined economy to grow 1.2 per cent in 2014.
And the benefits of healthier economic conditions do appear to be trickling down to the banks. Here in the UK the Bank of England’s first-quarter credit conditions survey revealed buoyant demand for most types of lending. Most noticeably, demand for mortgages rose again, with lenders expecting the trend to increase "significantly" in the second quarter. While credit-card lending remains depressed, most types of unsecured personal lending are also on the up. So, too, is business lending, with demand from medium-sized companies picking up sharply in the quarter. This should make for a virtuous circle. As economic recovery drives demand for credit, the banks will lend more, prompting an earnings recovery. With defaults falling fast, those earnings aren't being consumed by bad-debt charges.
So does that mean we on the verge of returning to that cosy pre-crisis world, when bank earnings only ever seemed to grow strongly and bank shares often came with fat dividend yields? Shares in Lloyds (LLOY) were yielding around 8 per cent when it announced its full-year results for 2007; the bank's return on equity stood at an impressive 25 per cent.
But things are never so simple. Despite all this evidence of recovery, it’s instructive that Lloyds still hasn't returned to the dividend list (although analysts at Investec think the bank could pay 1.5p this year). And its return on equity remains in negative territory (-2 per cent in 2013). Even over the medium term, it is only targeting a 12.5-14.5 per cent return. And it’s worth remembering that Lloyds's recovery is further advanced than that of some in the sector, as demonstrated by the government’s willingness to begin offloading its stake.
Moreover, it’s far from clear that credit conditions will remain as benign as they presently are. A base rate of just 0.5 per cent has certainly contributed to the recovery, but interest rates can't stay so low forever; some economists think the first rate rise could be less than a year away. True, higher interest rates will boost banks’ margins, but pricier borrowing could also hit credit demand and push up defaults.
Crucially, banks also face an altogether tougher regulatory environment. Basel III rules force them to hold more capital to absorb losses, as well as a stock of liquidity. This will leave them with lower-yielding assets and reduce their capacity to lend. Rating agency Fitch has estimated that Basel III will imply a reduction of more than 20 per cent in the returns of the world's most systemically important banks. Other costs, such as the UK's banking levy, aren't helping, either. The UK banks may not be the money machines they were in 2005-07 for many, many years.
Certainly, their shares aren’t expensive by historic standards. Those of RBS (RBS) and Barclays (BARC) trade on about 0.8 times forecast net tangible assets (NTA), while shares in the remaining three - Standard Chartered (STAN), HSBC (HSBA) and Lloyds - trade on about 1.3-1.4 times forecast NTA. During the latter part of 2007, shares in Lloyds were trading on a multiple of nearer 2.5 times.
But with post-crisis structural factors likely to impede returns for the forseeable future - and with the possibility that the recovery in credit conditions could yet prove less robust than hoped - that cheapness isn’t necessarily enough to justify jumping back into the sector. For now, my view is that caution remains wise.
