Are UK banks' recovery prospects looking up?

On 9 November, the day Pfizer and BioNTech announced their vaccine candidate was more than 90 per cent effective in preventing Covid-19, the world allowed itself to hope again. Since then, the London Stock Exchange has provided few better examples of the renewed optimism shared by investors than the rally in UK bank stocks, which have outperformed the broader market.

The FTSE 350 Bank Index is up by almost a fifth, beating the All-Share benchmark by more than 8 percentage points, while domestically-focused lenders have fared even better. Shares in the lowly-valued Virgin Money (VMUK) have surged 51 per cent, sink-or-swim challenger Metro Bank (MTRO) is up 92 per cent, and Lloyds Banking Group (LLOY), the UK’s largest high street player, has seen its market value rise by 24 per cent (see price chart).

On the surface, this outsized relief rally makes sense. If bank shares represent leveraged bets on economic activity, the sudden revision to the outlook for consumption, employment and business investment that accompanied the vaccine news were all unqualified positives. Put simply, lending looks like a less risky venture than it did at the start of November.

But with shares in the sector once again plateauing – and still trading at lower valuations than they did a year ago – it’s unclear whether the recent flash of bullishness can be sustained. Over the next fortnight, the publication of banks’ fourth quarter and full-year results should offer the clearest window into the outlook for dividends, asset quality and earnings since the pandemic first hit.

The virtues of deal-making

Insofar as Wall Street’s largest names can be compared with UK lenders, the earnings season from across the Atlantic offers some promise. Last year proved enormously successful for many of the largest names in US finance, as volatility and then unprecedented fiscal and monetary support in the engine room of global finance kept bankers and traders busier than at any time since the financial crisis. Morgan Stanley (US:MS), whose cheap valuation we highlighted immediately after the US presidential election, led the pack, posting fourth quarter pre-tax income of $3.2bn (£2.3bn), up from $1.1bn a year earlier.

According to Berenberg, the major listed US lenders saw a 23 per cent surge in combined investment banking revenues, as mammoth trading volumes across equities, fixed income, commodities and currencies were supplemented by frenetic capital markets work. Deal-making fees rose 32 per cent across the patch, in the strongest outing for the sector in more than a decade.

Among the UK’s largest listed lenders, the clearest beneficiary of the upsurge in corporate work is Barclays (BARC), which reports on 18 February. The group has expanded its investment bank under chief executive Jes Staley, despite continuing pressure from activist shareholder Edward Bramson to can the unit. However, the FactSet-compiled consensus forecast is for a 22p loss per share in the fourth quarter, and total revenues of £4.58bn.

But those forecasts therefore look beatable, particularly when you consider investment banking income makes up more than half the top-line. Rival Deutsche Bank (Ger:BDK) just defied expectations to post its first net profit in six years, too. City sentiment toward Barclays also remains upbeat, with all but one of the analysts rating the stock a ‘buy’ or ‘hold’ (see chart).

Flash in the pan?

Pessimists will point to the lumpiness and inconsistency of these earnings, as well as the risks the pandemic continues to pose to credit quality. Even Morgan Stanley boss James Gorman thinks the chance of a repeat of last year’s bumper earnings in 2021 is unlikely, which raises the stakes for the vanilla mortgage lending that for Barclays is a second order capital priority and a core concern for Lloyds Banking Group (LLOY) and NatWest (NWG).

Fortunately, the early signs are encouraging. Santander (Sp:SAN) both grew the interest spread on its UK lending in the fourth quarter and smashed consensus profit expectations for the country by 35 per cent in the three months to December. First quarter figures for Virgin Money (VMUK), published last week, were another source of optimism. The lender, whose financial year runs to September, returned to statutory profit despite booking another £49m charge for missold payment protection insurance.

Customer deposits edged up 0.9 per cent in the period, while the mortgage book shrank slightly amid a focus on the net interest margin and tighter underwriting standards. Loans to small businesses, a key plank of Virgin’s growth ambitions, remained flat as demand was met by another £1.3bn in government-backed credit.

Management commentary was also upbeat. Virgin said it had “not seen material changes in asset quality or specific provisions to date” as bad loan reserves fell 1.1 per cent to £726m during the quarter. The combination of rising house prices, stable credit and stable net interest margins augurs well for the broader market.

Should this pattern hold in fourth quarter figures for Lloyds, then shareholders in the UK’s most widely-held stock may be in for a pleasant surprise. A full-year consensus pre-tax profit forecast of £1.6bn assumes credit impairments will hit £4.7bn, from £4.1bn at the end of September. If, as Virgin’s loan loss revisions suggest, that is too onerous, then Lloyds profits or capital position might look better than many are reckoning.

Damage limitation is, of course, a good place to start. But this doesn’t mean income-generating prospects have suddenly turned a corner. Metro Bank’s (MTRO) decision to sell a third of its mortgages to NatWest and recycle the proceeds into a book of unsecured consumer loans is the latest chapter in one bank’s efforts to trade its way out of a hole and sacrifice credit quality for income.

But it is also a sign of the broader earnings challenge facing a sector whose brightest hope – Lloyds – is still only expected to generate a 5.3 per cent return on equity in 2021. Capital rules also mean shareholder distributions will remain subdued for the time being.

Negative rate talk persists

This year, bank executives have two other communication challenges on their hands. The first concerns managing fallout from the bounce-back loan scheme, amid reports of fraud and weak checks. Though banks have acted as administrators rather than underwriters of the emergency lending schemes, and therefore won’t be on the hook for credit losses, they could still find themselves in the crossfire if taxpayer funds are seen to have been misused.

A second challenge looms in the ever-vague shape of negative interest rates, which the Bank of England continues to entertain. So long as Threadneedle Street dangles the possibility of depositors paying to keep their holdings in cash, then UK banks cannot be seen as true value stocks (see table). A re-rating toward book value would likely require this cloud to lift entirely, and be replaced with manageable inflation and the realistic prospect of higher interest rates. Long-term bond yields may be rising, but financial markets have a lot further to go.   

Dividend restrictions aren’t a disaster so long as capital is building and executives can think creatively about growth opportunities outside mortgage lending. But for domestic UK lenders, hopes of a market-beating re-rating from here appear to rest on a reflationary trade and several years of steady economic growth ahead. Neither seems cut and dried.