UK banks' targets on the slide

This dynamic is particularly relevant to bank stocks, which tend to be more sensitive to day-to-day market conditions than most. And as anyone who has invested in the sector since the financial crisis will know, 'one-off' corporate or litigation charges also have pronounced effects on earnings figures. The short-term noise can often feel entirely negative.

That’s especially the case when the time horizon is reduced to a mere quarter. Three months is usually short enough for hits (and the occasional boost) to a bank, but nowhere near long enough for multi-year strategic battles against low interest rates to bear fruit.

However, scan through the UK banks’ latest earnings season, and it’s hard to conclude that all is well, on a near- or medium-term view. For buy-and-hold investors – which in the case of the Royal Bank of Scotland (RBS) still includes the entire British public – the day-to-day noise is beginning to sound more like a continuous drone. And as executives’ return targets continue to slide, disciplined conviction can feel increasingly like hope.

A better backdrop?

Ahead of third-quarter results, momentum was with the big banks. At the start of October, investor fears of a hard Brexit quickly gave way to optimism that the UK and the European Union could secure a deal. Hopes of improved domestic business and economic conditions were immediately reflected in the share prices of the lenders with the largest UK exposures – RBS and Lloyds Banking (LLOY) – which rallied by 29 and 20 per cent, respectively, in the fortnight to 21 October.

A month later, that sudden burst of optimism feels like a world away. Lloyds has again warned that economic uncertainty could impact its outlook. Despite the apparent turn in market sentiment, RBS has not budged from its August warning that next year’s return on tangible equity of at least 12 per cent is unlikely. HSBC (HSBA) no longer expects to hit an 11 per cent targeted return on tangible equity in 2020. And Barclays (BARC) shaded its own 10 per cent target for 2020, pointing to an “unquestionably more challenging” operating environment than a year previously, when the goal was set.

Return on targeted equity

Despite this, Barclays probably recorded the best performance of the UK-based lenders. If investors strip out litigation and conduct charges – as they have been asked to for a decade – then pre-tax profits came to £1.81bn, and the group return on tangible equity came to 10.2 per cent, ahead of a 9 per cent target for the current year.

The results provided further evidence that chief executive Jes Staley’s decision to persevere with Barclays International – the firm’s investment bank – is paying dividends. Rising income here, together with some favourable currency movements, helped to offset a rise in credit impairment charges and investments in digital products.

And while the division’s cost base remains higher than Barclays’ personal and commercial business – providing, of course, that you adjust for the latter’s litigation and conduct charges – the international business boasts a 4.0 per cent net interest margin so far this year. Although this is down 15 basis points on the same period in 2018, it’s worth noting that the Federal Reserve’s funds rate has dropped by five times as much since December.

Consequently, Barclays still leads the pack in underlying profitability, and probably looks the most capable of hitting its intermediate targets. Even the £1.4bn additional provision for payment protection insurance (PPI) claims booked in the third quarter was below the upper range flagged in September amid a pre-deadline spike in claims.

Peaking profits

Hopes that RBS's and Lloyds’ final PPI bill would be anything less than the top end of previous estimates were dashed as the lenders were forced to swallow £0.9bn and £1.8bn hits to their respective statutory profit lines.

By this point, investors’ shrug reflex has been well-trained. But since the window for claims closed in August, the possibility of unexpected billion-pound write-downs with each financial report has also receded.

From a noise-cancellation perspective, that should be a positive, as it gives investors a clearer sight of how the UK-focused banks are doing, for good or bad. In the case of Lloyds, which has paid out more than half its current market capitalisation in PPI redress, that means arresting a recent rise in bad loans. Indeed, the asset quality ratio – of impairments to total lending – rose to 33 basis points following “a single large corporate charge”, possibly due to the collapse of client Thomas Cook.

Investec analyst Ian Gordon reckons that Lloyds’ rising impairments and falling revenues are now running ahead of the bank’s efforts to cut costs. As a result, he estimates that pre-tax profits have peaked “in the current cycle”, a view that appears to be supported by a small downward revision in the group’s full-year net interest margin, to around 2.88 per cent.

It’s the sort of margin that RBS’s new chief executive, Alison Rose, can at this stage only dream about. In the three months to September, her bank's net interest margin stood at 1.75 per cent, a 29 basis point drop since the start of 2018. The latest roll-call of headwinds include competitive pressures in the mortgage business, which are eating into front book margins, while core income in NatWest Markets – the group’s corporate banking division – has cratered.

Ms Rose will soon need to outline her plans for the latter division, and the similarly-underperforming Ulster Bank. If investors were looking for clues in her inaugural staff address last Friday, then they will need to hold their breath a little longer. In fact, investors were given only a cursory mention in an in-house presentation, which suggested that culture and social engagement are the new boss’s first priorities.

Chop and change

Banking bosses have myriad ways to leave their marks on an institution. Regardless of whether HSBC interim chief executive Noel Quinn lands the top job full time, his third-quarter audition for the role showed an appreciation for the labyrinthine lender’s culture of permanent revolution. After pre-tax profits fell 18 per cent to $4.8bn (£3.7bn), Mr Quinn vowed to remodel the business, cutting harder and faster than previously planned.

Although social unrest in Hong Kong has added a large caveat to the group’s much-trumpeted Asian exposure, investors were braced for neither the poor earnings report, nor the dramatic response.

In the event, trading in protest-hit Hong Kong was described as “resilient”, and contributed to a 4 per cent rise in third-quarter pre-tax profits in Asia. But other regions floundered. Earnings fell in North America, Latin America and the Middle East and North Africa businesses, while Europe swung to a statutory loss of $424m (£330m) for the period, compared with a $634m profit in the third quarter of 2018.

Rising credit losses, together with lower interest rates, lower capital markets activity and “wealth and insurance headwinds” have only added to the pain. In a hurry to stop the rot, the lender now believes that underperformance has been exacerbated by placing “too much capital” in continental Europe and the non-ringfenced bank, and has pledged to move capital from lower- to higher-return businesses.

That looks set to add further complexity to the group’s ongoing restructuring, and may result in “significant charges” from the fourth quarter onwards. The overview is a far cry from June 2018, when the group said it was time “to get back into growth mode” and promised a “return to value creation”.

Moving the stock to a ‘sell’ rating, analysts at Berenberg described the new strategy as “well-intended but poorly timed”, arguing that lower interest rates, and trade and political tensions across HSBC’s key markets have left the shares’ premium to the sector looking fragile, and unwarranted. And while the analysts think the capital reallocation plans could boost group returns by up to 100 basis points and release $10bn of capital, they expect any benefits to be neutralised by the bank’s unrepresentative cost allocation and the possible hit to revenues. “Based on peers’ experience, this alone could offset potential return on tangible equity benefits,” Berenberg concludes.

As with the UK-focused stocks, HSBC’s dividend looks assured, although the likelihood of “significant” impairments threaten to further reduce HSBC’s tangible net asset value, against which the shares already trade at a premium.

How the UK's biggest banks compare