Banks unable to build on rate rise bounce

Shares in UK banks have failed to build on the gains made following the Bank of England’s decision to increase the base rate of interest for the first time since the start of the coronavirus pandemic.

The bank nudged up its base rate to 0.25 per cent, from 0.1 per cent, on 16 December in a bid to curb fast-growing inflation, despite the threat of the UK economy heading into a recession as new measures were introduced to stem the spread of the Omicron variant.

This led to shares in Britain’s biggest bank, Lloyds (LLOY), jumping 5 per cent on the day, while HSBC (HSBA), NatWest (NWG) and Barclays (BARC) all rose by 3.5 per cent.

This climb was part of a “knee-jerk reaction by the market", as investors hurried to switch to sectors that typically benefit from interest rate increases, said Colin Morton, head of UK equities at Franklin Templeton.

Two weeks on, however, the gains appear short-lived. Bank shares initially rose on their perceived ability to widen the spread between the interest they offer to savers and the amount they charge borrowers, but Morton noted that the prospect of further rate rises seems limited.

Marginal gains

Interest rate futures contracts suggest rates could edge up to 0.75 per cent over the next six to eight months, and to just over 1 per cent over the next 12-24 months, he said.

“A lot of people think the top of this interest rates cycle will be [a figure] with a one in front of it. We’re not talking about interest rates going back to 4, 5 or 6 per cent,” Morton said.

That, and the potential damage the rapidly spreading Omicron variant could do to the UK economy, means optimism remains in short supply.

Lloyds, which is seen as a bellwether for the domestic economy given its limited overseas or investment banking activity, closed on Christmas Eve trading at 47p a share. That was 2 per cent higher than the 46p it reached on the day of the rate rise, but below the 50p level of a month earlier, before restrictions aimed at curbing the spread of Omicron were announced.

HSBC shares remained flat, while NatWest shares gained just 1 per cent. Barclays, which typically makes more profit from its global corporate and investment banking arm than its UK retail business, saw its shares rise 3 per cent.

“We think Omicron is likely to slow growth over the next few months, along with other headwinds such as tax rises, supply bottlenecks, high energy prices and some limited pass-through from the rate hike,” analysts from Credit Suisse said in a note following the rate rise.

Once winter turns to spring, however, the analysts expect “a robust pace” of economic growth given that both household and corporate balance sheets are in good shape and the labour market remains tight. 

Credit Suisse expects two interest rate rises of 0.25 per cent next year – one in May and one in November – as well as a policy of 'quantitative tightening' as the Bank of England begins to wind down its asset purchase programme.

Ratings agency Fitch expects the central bank to raise rates just once next year to 0.5 per cent, as gross domestic product (GDP) growth slows from a predicted 6.9 per cent this year to 5 per cent in 2022.

Risk kept in check

Competitor Moody’s also expects GDP growth to decelerate and believes “temporary” inflationary pressures will ease, suggesting interest rates will remain lower for longer. Although this means the opportunity for banks to widen spreads will be limited, it also keeps default risks in check.

The share of UK banks’ loans deemed ‘Stage 2’ under IFRS rules – the point at which credit risk has significantly increased – has grown from above 6 per cent in 2019 to a current level of almost 14 per cent, according to Moody's.

Swiss bank UBS believes that downside risks for banks are limited, though. It expects a “delayed-not-denied” delivery of strong GDP growth next year, with higher inflation driving monetary tightening by central banks across the major economies.

“Our fixed income experts expect the biggest increase in real yields since 2013,” the bank's analysts said in a note, forecasting a 1.45 percentage point increase in 10-year gilt yields.

Banks are also geared for loan book growth, with UK banks' loan-to-deposit ratios falling to 88 per cent, compared with 93 per cent prior to the pandemic in 2019. It is a similar story on the continent, where European lenders trade at a fairly low average multiple of 7.1 times next year's adjusted earnings per share, UBS analysts said.

Morton thinks “the environment is going to remain very tricky” for banks to make profits without a significant rise in interest rates, though, as the industry remains highly competitive.

An investor looking to benefit from expected interest rate rises might be better served by buying shares in companies with closer ties to the retail investment industry.

Hargreaves Lansdown’s (HL) shares also rose by about 5 per cent on the day of the Bank of England's announcement. The investment platform was upgraded by Numis due to the rate hike's positive impact on its high-margin cash savings business. Investment managers also continue to perform well on the back of rising asset prices and an imperative for people to save more for their retirement, Morton said.

The manager believes non-financial companies also remain attractive. Although shares in utilities companies offering a steady income yield took a dip on 16 December as the return on cash deposits increased slightly, they still “look attractive”, he added.

SSE’s (SSE) dividend yield has averaged 6.7 per cent over the past five years, while National Grid’s (NG) averaged 5.4 per cent, according to FactSet.

“I still think that looks incredibly attractive compared to interest rates where they are and 10-year bond yields below 1 per cent,” Morton said.