If the fortunes of the UK banking sector looked uncertain at the start of 2016, the political shocks during the months that followed have thrown up even more questions for this year. At least there was movement on interest rates: the Federal Reserve raised its core funds target range by 25 basis points for only the second time since before the financial crisis. It has now flagged three further rises this year, spurred by a stronger economy and expectation of president Donald Trump’s inflationary fiscal policies; so-called ‘Trumpflation’.
This has led some to argue that the Bank of England (BoE) will, as usual, follows the Fed’s lead – especially given the domestic outlook for inflation after the devaluation of sterling. This would be good for UK banks, which have had their net interest margins pinched even harder this year following the BoE’s 25 basis point reduction in its core rate, intended to shore up confidence after the Brexit vote.
Lower interest rates suppress the margin that banks can make on long-term loans over the interest they pay on their short-term deposits. In a rising rate environment, they can boost profits by not passing through the higher income to customers straightaway.
According to UK Treasury forecasts, UK consumer prices inflation (CPI) is expected to rise to 2.8 per cent by the end of this year, which would provide added impetus for a rate rise. BoE governor Mark Carney has also said the central bank would increase its growth forecasts for 2017 after a more resilient economic performance during the fourth quarter of last year.
But the economic outlook is not quite that simple. During its December meeting the BoE’s monetary policy committee said it was prepared to “look through” higher inflation in order to protect economic growth, even if inflation surpassed its 2 per cent target. And Mr Carney has said that while Brexit is no longer the major risk to economic stability, rising consumer credit, weaker sterling and squeezed real household income were grounds for concern.
Still, there are signs that some UK banks have made progress in increasing their resilience to shocks. Almost all the UK-listed banks passed last year’s stress test, which applied a hypothetical UK and global recession. Lloyds (LLOY) performed the best, with its core capital ratio falling to 9.7 per cent after the stress scenario was applied, but clearing its 7 per cent hurdle rate. Royal Bank of Scotland (RBS) was the only bank to fail the test even after including debt that can be converted into equity, forcing it to present the BoE with a revised capital plan. With the largely taxpayer-owned bank facing a big fine from US regulators and a (reduced) civil action over its 2008 rights issue, there are further near-term threats to its book value.
Emerging-market focused banks HSBC (HSBA) and Standard Chartered (STAN) enjoyed a recovery in their share prices during the latter half of 2016. HSBC's 'Asia pivot' is vital: two-thirds of its adjusted pre-tax profits came from the region during the first half of last year. With Asia still heavily dependent on Chinese trade, the risk is that China’s distorted debt-fuelled growth strategy comes back to haunt it, with foreign investors pulling more money out of the country. If there is a further slowdown in Chinese growth, HSBC and StanChart stand to suffer most, and the extent to which president Trump follows a promised protectionist stance against China will also be critical.
It's not just mainstream banks that have had problems. Challenger banks OneSavings Bank (OSB), Shawbrook (SHAW) and Aldermore (ALD), which have significant buy-to-let lending operations, faced testing times during the past 12 months as the tax burden was increased on landlords. After experiencing a spike in applications for buy-to-let mortgages before the changes came into effect in April 2016, lending fell thereafter. Further reductions in tax relief may reduce demand from everyday landlords, but it’s worth noting that the majority of these borrowers have professional landlord clients that will be more able to insulate themselves from the changes.
| Price (p) | Market value (£m) | PE (x) | Yield (%) | 1-year change (%) | Last IC view | |
| Aldermore Group | 221 | 762 | 9.1 | 0.0 | 17.6 | Buy, 145p, 11 Aug 2016 |
| Bank of Georgia | 2,805 | 1,108 | 9.3 | 2.8 | 69.7 | Hold, 2,668p, 23 Aug 2016 |
| Barclays | 228 | 38,608 | 13.7 | 2.9 | 21.3 | Buy, 224p, 23 Dec 2016 |
| CYBG | 287 | 2,532 | 17.7 | 0.0 | NA | Hold, 285.7p, 23 Nov 2016 |
| HSBC | 679 | 137,061 | 18.4 | 5.5 | 41.5 | Hold, 499p, 03 Aug 2016 |
| Lloyds Banking | 65 | 46,528 | 8.3 | 3.6 | 1.9 | Buy, 63.95p, 29 Dec 2016 |
| Metro Bank | 3,150 | 2,531 | NA | 0.0 | NA | Hold, 2,061p, 27 July 2016 |
| OneSavings Bank | 324 | 786 | 11.2 | 3.0 | 4.6 | Buy, 352p, 15 Dec 2016 |
| Royal Bank of Scotland | 219 | 25,893 | 8 | 0.0 | -15.8 | Hold, 176p, 28 Sep 2016 |
| Shawbrook | 245 | 614 | 9.4 | 0.0 | -19.6 | Hold, 184.5p, 28 Jul 2016 |
| Standard Chartered | 746 | 24,485 | NA | 0.0 | 52.4 | Hold, 747p, 28 Jan 2016 |
| Virgin Money | 309 | 1,374 | 15.5 | 1.5 | 6.6 | Buy, 263p, 27 July 2016 |
Favourites: Recent buy tip Lloyds remains our favourite in the sector. The bank is very well capitalised, with a common equity tier one ratio of 14.1 per cent. The retail bank was able to triple its dividend for the 2016 financial year, including a special payout, and at the half-year stage of the current financial year, management increased the dividend again by 13 per cent to 0.85p a share. This was ahead of market consensus, which had assumed it would be maintained at 0.75p.
Outsiders: RBS is a high-risk investment at present, given the challenges it faces on both sides of the Atlantic. There is also the long-running spin-off of Williams & Glyn, which recently listed challenger bank CYBG (CYBG) is in the running to take over. The sale is reportedly hampered by the technology risks involved in transferring customers to a new system.
