Should you invest in banks in a context of higher inflation?

UK banks have been largely overlooked and unloved by investors in recent years, and perhaps for good reason.

Over the past decade, the FTSE All-Share has generated a total return of 99.6%, while the UK banking sector has earned a meager 17.5%.

This dismal performance is largely due to the lowest interest rates and tight monetary policy since 2009.

Dull: Lowest interest rates and tight monetary policy have seen retail banks perform poorly in recent years

But the UK continues to have significant exposure to the financial sector – around 8% of the market – so some investors may reconsider their aversion to high street lenders.

Will rising interest rates help support their stock prices or will the cost of living crisis weaken consumer confidence and their outlook for the year?

One of the biggest headwinds for the banking industry since 2009 has been rock-bottom interest rates.

Banks generally make money by accepting deposits and lending them to borrowers at higher rates and for a longer term.

They can also take long-term, non-interest bearing deposits and hedge them using interest rate swaps. These form the net interest margin (NIM) of a bank, but they have been reduced during this prolonged period of low rates.

So, will the banks applaud the Bank of England’s fourth rate hike in six months?

Bank of England Governor Andrew Bailey has warned of a massive downturn

Bank of England Governor Andrew Bailey has warned of a massive downturn

“Rising interest rates are good news for banks as they allow them to earn a higher net interest margin,” says James Yardley, senior research analyst at FundCalibre.

“For years, very low interest rates have made this incredibly difficult. Even a small change can have a big impact on such a well-oriented business.

Ahead of the Monetary Policy Committee’s decision to raise the base rate, Lloyds said it expected a NIM of 270 basis points, down from 250, and a return on tangible equity above 11% this year.

Yardley adds: “The other thing banks have going for them is that they are very unloved and often trade below or close to book value. This means that you don’t need to see much positive change to see a huge improvement in stock prices.

Challenger banks pose an existential threat

In addition to grappling with high inflation and the prospect of another recession, banks must also deal with an increasingly saturated market.

“There is a lot of competition between established players and also from fintech and digital-only rivals – and this is forcing incumbent banks to invest heavily in IT and their service offering, at the possible expense of short-term profits. term. The regulator continues to monitor the sector closely,” says Mould.

The powerful challenger trio of Starling, Monzo, and Revolut have quietly built strong, and perhaps more importantly, loyal customer bases and secured high investments.

Starling, which has been profitable on a monthly basis since October 2020, recently raised £130.5m “to build up a war chest for acquisitions”.

The funding round gives a pre-money valuation of over £2.5bn for the UK bank and founder Anne Boden has indicated that the fintech is aiming to go public next year.

Mr. Mold says: “Customer loyalty has been severely eroded by the financial crisis and banks are still not necessarily held in high esteem, which may explain why new market entrants may gain traction, at least in customer acquisition terms.

“All of this makes it pretty difficult to grow, at least without taking on risk by lending money to those who already have a lot of debt, or through investment banking, which can be great in boom times. and working very hard during market downturns.

“This may explain the drive towards wealth management and private banking, as customers are more sticky and fees can slowly add up, provided customers feel they are getting good service, that fees are not too high and that nothing jeopardizes their heritage.”

But if interest rates continue to rise sharply, it could chill mortgage markets and lead to higher bad debt among consumers “who will also feel the pinch of inflation and the sharp rise in the cost of living”, says AJ Bell Chief Investment Officer Russ. Mold.

“Higher loan provisions could still weigh heavily if the economy spins in circles under the weight of rising interest rates.”

Yardley adds: “The downside of higher rates is that it could trigger problems in the housing market, as we saw in 2007 and 2008. With house prices currently so high relative to incomes, the market is vulnerable if housing demand collapses.

“A collapse in property prices would be very bad news for banks. We have already seen banks start to position themselves for more mortgage defaults.

While banks have welcomed the recent rate hike, they are unlikely to feel the same enthusiasm about its economic prospects.

The central bank issued a pessimistic forecast: it now expects inflation to peak at 10% at the end of this year, due to a further 40% rise in energy prices in India. fall.

This, coupled with the risk of recession, is not a good prognosis and even with rising rates, banks will suffer.

“As the UK economy appears to be slowing…and inflation hit a 30-year high of 7% in the 12 months to March with expectations of double-digits in the summer – this serves up a bitter economic cocktail of rampant inflation, decelerating growth and rising interest rates, which even the banking industry will have a hard time swallowing,” says Alice Haine, personal finance analyst at Bestinvest.

“Add in the fallout from the war between Ukraine and Russia, such as sky-high energy prices, and it’s no wonder Brits are tightening their belts or having to borrow more to maintain their lifestyle – money they may not be able to pay back as things get worse.

Bank of England figures show high street lenders expect a rise in the number of consumers struggling to repay credit cards and other loans as the cost of living crisis continues to bite.

Lloyds boss Charlie Nunn recently said the bank is contacting customers “where [it] believes they may need help and will continue to help with financial health checks and other means of support.

He added: “While we are seeing a continued recovery from the coronavirus pandemic, the outlook for the UK economy remains uncertain, particularly in relation to the persistence and impact of higher inflation.”

Add to the fact that Lloyd’s have increased their pot to cover bad debts by £177m and it’s clear they are worried about an increase in defaults.

Sophie Lund-Yates, senior equity analyst at Hargreaves Lansdown, added: “Things are nowhere near crisis levels, but a sharp economic downturn would hurt all banks.”

Cash-strapped: Britons are tightening their belts or forced to borrow more to cover expenses, which could mean banks have to spend more to cover defaults

Cash-strapped: Britons are tightening their belts or forced to borrow more to cover expenses, which could mean banks have to spend more to cover defaults

The headwinds that have plagued the sector since the financial crisis are likely to weigh on them throughout this year and next.

This could mean banks continue to be an unloved sector for investors, but Mr Mold suggests it could mean they are undervalued.

All five banks listed on the FTSE 100 are trading at a discount to net asset value per share.

“On the face of it, all five also easily meet regulatory capital requirements, given high CET1 ratios and relatively low leverage ratios, so in that respect they have held up quite well in the pandemic,” Mr. Mould. “Especially since they’ve spent much of 2021 writing off bad debt provisions they took in 2020 because their worst-case scenario didn’t materialize.”

If you think bank stocks are unfairly unloved and undervalued, there are plenty of opportunities to gain exposure to the sector.

The good news is that banks are not expensive. The bad news is that they may deserve to be, especially if the economy is slowing down.

Russ Mold, Chief Investment Officer of AJ Bell

Haine says: “Banks are well represented in the UK stock market, accounting for 8% of the market, so a simple tracker like the Fidelity Index UK fund will provide exposure.”

She also points to TM Redwheel UK Equity Income, run by Ian Lance and Nick Purves, which targets undervalued companies.

“Since December last year, when the BoE raised rates for the first time since the start of the pandemic, bank stock prices are now slightly ahead of the broader marker – although they have sold aggressively in mid to late February before recovering,” Haine said.

“How they perform during 2022 will depend on their ability to manage the economic challenges ahead.”

Yardley points to Polar Capital Financials Trust and Jupiter Financial Opportunities, which have returned 54.9% and 27.41% respectively over two years but “have suffered in recent months along with the broader market”.

Mr. Mold adds: “The good news is that banks are cheap. The bad news is that they might deserve it, especially if the economy slows, but a mildly inflationary recovery with slightly higher interest rates and solidly performing stock markets would be a boon.

“It remains to be seen whether central banks can engineer such a soft and dreamy landing.”

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About Christopher Easley

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