Four things to look for in banks’ results season

Since February 2020, bank stocks have served as a litmus test for economic hope and despair.

Shares in UK stalwarts Lloyds (LLOY), NatWest (NWG) and Barclays (BARC) dived as investors scrambled to price in spiking credit risk and fears around market liquidity. Those domestic names, along with the more Asia-focused HSBC (HSBA) and Standard Chartered (STAN), all shot higher as a combination of fiscal support and then scientific breakthrough raised prospects for an economic rebound.

Now, with the wildest swings in real and forecast economic activity in the rear-view mirror, the outlook for interest rates has risen to the top of the agenda, and looks set to once again determine sector sentiment.

The good news is that no-one in the City is talking about negative rates anymore. At the start of 2021, the Bank of England continued to dangle the possibility of depositors paying to keep their holdings in cash, in a move which threatened to upend UK banks’ business models and further dent shareholders’ hopes of medium-term profit growth.

In February, we suggested that this cloud would need to lift entirely for the sector to have a hope of re-rating toward book value.

Six months on, and there are real reasons to expect banks can benefit from the current macro-economic backdrop. Chief among these is inflation, which has risen faster than many expected and led investors to bring forward their expectations for tighter monetary policy and – potentially – higher interest rates.

Assuming inflation is both sustained and manageable, this raises the prospects for net interest income, as banks re-price loans and juice their returns on equity.

Analysts at Axiom Alternative Investments reckon European bank shares could rise by more than 50 per cent if the so-called risk-free yield on 10-year US Treasury bonds climb at a similar clip to the 2016-18 period. “As the inflation debate rages, it makes little sense to assign zero value to the strong rates optionality,” the Paris-based fund manager wrote. In other words, rule out higher interest rates and miss out on potential bank share price gains.

The correlation between bond yields and bank equities is reasonably strong, as the chart below shows. This stands to reason: if investors think banks’ earnings will improve, they are generally casting a vote on a better outlook for the broader economy. In this scenario, the relative attraction of bonds reduces, leading investors to increase their allocations to equities and ‘risk-on’ assets and forcing bond yields lower.

Recently, the momentum which kicked on last autumn with the positive vaccine news, powering value stocks like banks higher, has cooled. Falling bond yields also imply that many long-term investors believe the recent uptick in inflation will prove transitory.

If they are right, UK banks will once again be tarnished with the weak-growth, high-cost, high-vulnerability narrative. Conjecture around higher interest rates could prove to be sector bulls getting ahead of themselves, again.

For now, however, investor minds will be focused on the financial and strategic decisions the banks will announce over the coming fortnight. Below are four stories to look out for as the sector opens its books.

1. Changes to provisions

Quite how bullish investors should be about the upcoming earning season may depend on their reading of a recent trading update from lending minnow Secure Trust Bank (STB). On 12 July, the group said an improvement in the economic outlook would lead it to slash impairment provisions booked last year.

The accounting tweak means the board now forecasts pre-tax profits for 2021 will be “materially ahead of current market expectations” of £29.5m and above the top end estimate of £36.8m. Though the bank “remains cautious on the near to medium term UK economic outlook”, that didn’t stop a 7 per cent surge in the shares on the announcement.

There were already signs that some of the billions of pounds in credit charges could start to unwind with a brighter outlook for the UK economy. In its first quarter numbers, Lloyds booked an impairment credit of £323m after an upward revision to its outlook drove a £459m reversal of expected credit losses.

At the time, the country’s largest high street bank said it still expected “a large proportion” of its write-downs will be realised as government support measures fade and unemployment rises. But signs of further releases will be treated as a strong signal that executives believe the most severe threat to loan books has passed.

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2. Capital returns

Write-backs to provisions booked last year, if they happen, are only going to strengthen banks’ mammoth capital positions, and with it the case for shareholder returns.

Investors in UK lenders were left reeling at the start of the pandemic when the Bank of England, together with several other major central banks, banned banks’ capital distributions. In December, the blanket ban was lifted, albeit with significant caveats.

The central bank has now removed all restrictions on bank dividends and share buybacks, after it deemed the sector’s capital levels to be sufficiently strong to handle any further hits from Covid-19. “Extraordinary guardrails on shareholder distributions are no longer necessary,” the regulator confirmed earlier this month.

The degree to which this has been priced in by income-seeking investors is unclear. Over the last three months, analysts’ expectations for second quarter dividends have broadly lifted, with HSBC rising from 3.6p to 4.4p, Barclays surging from 1.15p to 2.55p and NatWest doubling to 2.1p.

Understandably, there is little consensus on the likelihood of one-off distributions. Share buybacks, Barclays’ preferred distribution tool, continue to make sense so long as sector shares trade at wide discounts to tangible book value and executives can chart a path to earnings growth.

But while near-term estimates vary widely, the City now expects each of the FTSE 100 banks apart from StanChart to yield at least 4 per cent, with Lloyds the top dividend pick.

3. Barclays' golden goose

Wall Street, whose stronger relative exposure to corporate lending, wealth management, advisory services and securities dealing helped them outperform their UK peers in 2020, received a more muted market reaction when it reported second quarter numbers this month.

Compared with the frenetic trading and lending activity seen at the very start of the pandemic, the three months to June were a lot lighter. Despite another purple patch for booming dealmaking activity, shrinking loan books and losses on corporate loans conspired with higher-than-expected cost inflation to depress earnings.

Barclays, whose international division sees it compete in the same waters as the US giants, is expected to post a smaller year-on-year decline in investment banking revenues. A double-digit decline here will be scored as another point to those who see the division as an expensive and unreliable source of earnings even though a deal-making hedge arguably helped it weather last year’s storms better than its retail-only domestic peers.

To do so might miss some encouraging signs.

“The bank appears to be gaining further market share in its fee businesses,” wrote analysts at Berenberg earlier this month, pointing to the bank’s strong presence on publicly-disclosed M&A deals. “We believe this provides a highly supportive backdrop which can be bolstered further by clarity over Barclays' cost reduction plans.”

The brokerage believes that signs of falling costs, together with its capital return strategy, should be a strong enough signal to help the shares’ close their sharp discount to peers. Not only are Barclays’ earnings priced more cheaply than its rivals (see table), but the shares trade 40 per cent below tangible book value, more than any UK bank.

Meanwhile, there’s little sign that the pace of deal-making activity is slowing down. “I haven’t experienced something like this in several years now,” says one City-based investment banker. “No-one has stopped between January and July.”

4. Moves in wealth management

Currently, investors place little value on UK retail banks’ core services. This won’t have escaped the notice of sector executives, but it must be galling when the London-headquartered fintech Revolut can raise $800m at a $33bn valuation, even though it is loss-making, has no UK banking licence and offers slickly-packaged but commonplace products.

But despite the sector’s high barriers to entry, punished valuations in the public markets reflect the lack of a growth story. The mortgage lending which makes up the lion’s share of NatWest and Lloyds’ risk assets (and to a lesser extent Barclays’) is a commoditised product that has struggled to produce double-digit returns on capital since the financial crisis.

Wealth management has long been touted as a strategic necessity for retail banks, given their scale, client stickiness and the sector’s growth as seen by the ever-expanding investment platform and asset gathering. Analysts at RBC believe that banks could improve their pre-tax profits by 2.5 per cent by converting just a fifth of their excess deposits into off-the-shelf investment products.

The opportunity hasn’t gone unnoticed by Wall Street. JP Morgan just acquired robo-adviser Nutmeg, and Goldman Sachs plans to follow suit with its Marcus brand later in the year.

Could Lloyds soon follow suit? In May, Sky News reported that the bank was nearing a £400m takeover of savings group Embark. Confirmation of a deal could therefore spark hopes that the sector might have finally stumbled on a plan to diversify its income streams.