UK investors have started to warm toward Britain’s largest banks after a bumper quarterly earnings period but some are concerned “the easy wins may be over” with much of the positive vaccine and economic recovery news fully priced in.
This year the ‘big four’ banks have seen a stunning reversal of fortunes, delivering Q1 earnings above and beyond analysts’ expectations.
HSBC and Natwest, formerly RBS, saw profits rise 80% in the first three months of 2021, while Barclays’ nearly tripled to £2.4bn.
Lloyds enjoyed the most profound bounce back with pre-tax profits surging to £1.9bn, a far cry from the sub £100m it generated over the first three months of 2020.
Across the board the surge in earnings was due to a sharp drop in bad debt provisions.
During the height of the Covid crisis banks took out huge forward-looking provisions, anticipating huge losses and a wave of defaults. But government support, like the furlough scheme, have helped minimise job losses and prevented more businesses from going belly up.
UK equity managers are more positive than they have been on the domestic banks which have been viewed as a contrarian play for the last decade.
‘Big four’ banks are an attractive recovery play
Tyndall Real Income manager Simon Murphy is among those bullish on the sector based on the expectation of a solid recovery for most geographies around the world but especially the UK.
“A strong economic rebound will help top line growth for the banks and, given rising government bond yields currently, the outlook for net interest income (NII) margins is improving for all the banks,” Murphy says.
On top of that the banks should see more benefits from the high levels of pandemic-related provisions that will be gradually released this year and in 2022.
“We have already seen strong earnings ‘beats’ in the latest quarterly reporting season, mainly due to provision releases, and there is much more to go for.”
Premier Miton Monthly Income manager Emma Mogford (pictured) has upped her financials position, moving to a slight overweight after several years of being underweight the sector.
Mogford’s exposure is concentrated in two areas – UK domestic banks and non-life insurance firms. Of the big four banks she owns Barclays, Lloyds and Natwest, believing all three to be well placed to benefit from a UK economic recovery, which she thinks will “exceed current expectations”.
“The sector’s outlook has always been closely tied to underlying economic growth,” Mogford says. “With improving growth and falling unemployment comes better loan growth, better pricing on multiyear loans and lower bad debts.”
However, she adds that valuations will remain sensitive to expectations around interest rate rises in the future.
UK banks are still cheaper than their European counterparts
JPM UK Equity Core co-manager Callum Abbott says several of the UK banks’ valuations also remain attractive.
When the coronavirus pandemic hit banks were trading on similar multiples to the global financial crisis, despite having stronger balance sheets and significant government and central bank support than 2008/09, Abbott says.
While share prices have recovered since then, the domestic banks still look cheap especially compared with their European counterparts, he adds.
Barclays, for example, trades on a 0.5x book value, a discount to its 10-year average of around 0.6x and well below the average European bank that trades on 0.8x.
Abbot says: “The economy is rebounding rapidly, which drives lower impairments and increased activity in a number of their businesses. The strong economic rebound is also pushing interest rates up, which helps banks increase profits.”
Thanks to the regulator banning banks from paying dividends for most of last year they are now sitting on heaps of cash which can be returned to shareholders via share buybacks and dividends. “We expect handsome capital returns for several years to come,” he adds.
The easy wins may be over
Rathbone Income manager Alan Dobbie owns both Natwest and Lloyds. While he thinks the sector tailwinds are strong “for now” with scope for both banks to provide significant dividend payouts, he recently cut his exposure to Natwest on the basis that a lot of good news has already been priced in.
News of multiple Covid vaccines in November, a Brexit deal in December and improving economic data in Q1 2021 has seen Natwest’s and Lloyd’s share prices nearly double since September, he notes.
As such the Covid/Brexit valuation discount has “dramatically narrowed” with Natwest now on 0.8x tangible net asset value (TNAV) and Lloyds on 0.9x TNAV compared to 0.4x and 0.5x in September respectively.
“As is often the case, markets have moved well ahead of the economic reality, significantly reducing the upside opportunity,” says Dobbie.
“To outperform from here the banks need a smooth re-opening, a buoyant housing market and unemployment to remain under control as furlough winds down.
“Further outperformance is possible, but the easy wins may be over.”
New Covid-variants and lacklustre economic rebound could see sentiment sour
Murphy says the biggest risk facing the banks is that the economic outlook is not as rosy as analysts are predicting.
“Clearly if there were further material lockdown events driven by new variants of Covid-19 that would negatively affect the outlook for the sector.”
Dobbie agrees that if the economic rebound fizzles out and fails to get off the ground, sentiment toward the sector could sour.
“The major headwind facing the sector could well be sentiment,” he says. “Can fiscal stimulus and ‘levelling up’ push economic growth, inflation and interest rates beyond the lacklustre readings of the last decade? For us, the jury is still out.”
Diversified plays
Both Murphy and Dobbie prefer diversified plays on the sector.
Financials account for over a quarter of Murphy’s Tyndall Real Income fund but traditional banks make up just 7% of this exposure. He owns Barclays and Standard Chartered, both 3.5% of the fund, and has a 3.9% holding in UK buy-to-let lender OBS, which sits in his 9.5% diversified financials bucket.
Murphy says Barclays’ greater exposure to investment banking means it has a more diversified business model than Lloyds or Natwest, while Standard Chartered is “more directly geared to an improving revenue environment in Asia” compared to HSBC.
Meanwhile, OBS has been generating “outstanding returns” and because it sits in a specialist area of the lending market is less vulnerable to traditional headwinds facing the sector.
“We have no problem really with Lloyds, Natwest or HSBC at this stage in the economic cycle, but we prefer the three mentioned above and, as we run a relatively concentrated 30-40 stock portfolio, we feel comfortable with the exposure we have in these names,” he says.
The Rathbone Income fund’s 17.6% UK financials exposure includes traditional banks like Lloyds, Natwest and Close Brothers, life insurers like Aviva and Legal & General, non-life insurers Hiscox and a single asset manager, Jupiter.
“Financials is a large, highly economically sensitive, sector,” Dobbie says.
“For this reason, we try to make sure that our individual holdings have diverse drivers and do not simply combine to form a large, correlated bet on rising interest rates, inflation or GDP growth.”
