Lloyds Banking Group PLC (LON:LLOY) is among the ‘least preferred’ options for stockbroker Shore Capital, but, it believes that UK Banks are entering the economic downturn in “extremely good shape”.
The stockbroker, looking ahead to Q3 results later this month, says the sector is “fundamentally attractive” and rates all UK banks as ‘buys’ at this time – Barclays PLC (LON:BARC) is the broker’s top pick followed by Virgin Money UK PLC (LON:VM), NatWest Group PLC, and Lloyds.
Standard Chartered PLC (LON:STAN) and HSBC Holdings PLC (LON:HSBA), which remain skewed more to Asian banking, are also both rated as ‘buy' at Shore Capital.
Significantly, the stockbroker expects solid results when reporting begins, starting with HSBC on October 25, 2022.
“Notwithstanding the current challenging economic outlook, we still expect a solid set of results with widening net interest margins continuing to more than offset a rise in impairments, thus driving higher returns,” Shore Capital analyst Gary Greenwood said in a note.
“We believe the major UK banks are entering this downturn in extremely good shape. This reflects years of regulatory tightening post the Global Financial Crisis which has put their capital and funding positions on a very sound footing, along with a period of modest loan book growth in recent years.
“In addition, balance sheets are carrying an element of excess provision left over from the pandemic, which is now being recycled to help cover risk associated with the cost of living crisis," Greenwood added.
Investment banking activities are described by the Shore Capital analyst as “a curate’s egg” – with volatile and weak markets impacting primary business, which remains subdued (albeit he notes potential for the weaker pound to “catalyse cross-border M&A”), but, in contrast, activity is higher in secondary business (ie trading) particularly in fixed income, commodities and forex).
Greenwood, meanwhile, focussed on the dynamics in the mortgage market where the banks are navigating the rapid rises in interest rates in a country where the majority of mortgage customers are signed up on fixed rate deals.
He notes that most mortgages have fixed terms of two to five years, so rates will in time increase.
“A typical two-year fixed rate mortgage with a 75% loan-to-value new charges an interest rate of around 6% whereas this was closer to 1% two years ago,” the analyst pointed out.
He said: “On average, around one-third of fixed-rate mortgages in the UK come onto a new fixed-rate mortgage each year. Regardless of whether customers decide to refinance onto a new fixed rate mortgage or simply move on the standard variable rate, they will likely experience a big step up in their monthly payments, which alongside rising energy costs and general inflation, may be difficult to afford despite historical affordability tests having been carried out.
“It is typically not in the banks’ best interests to repossess even if a customer cannot afford to meet their monthly mortgage payments. Banks are likely to therefore seek ways of providing forbearance or alternative ways to lower monthly costs.
“We think the most likely solution is to term out the mortgage (so, for example, take a mortgage on a 15-year term and extend it to 20 years). While this would lower the monthly payment it would increase the long-term cost to the customer, so banks will still need to consider if this is in the best interest of the customer.”
Summing up, the analyst added: “We believe the [UK banking] sector has significant long-term fundamental value attractions and while near-term share price performance is likely to be volatile, there should be strong rewards for those investors willing to ride out the storm.
“We have not made any changes to our forecasts … and will perform a full model update once we are through the Q3 reporting season. In the meantime, we reiterate our positive sector stance with ‘buy’ recommendations … based on upside to fair value, our current order of preference is Barclays, Virgin Money, Natwest (LON:NWG) Group, Standard Chartered, HSBC, and Lloyds."
Shore Capital pitches ‘fair value’ at 62p per share for Lloyds (versus 43p in the market) representing some 46% upside, whilst it projects 325p as fair value for Barclays (versus 145p), and 365p for Natwest (versus 230p).
For HSBC it is 695p against a 471p market price, Standard Chartered is 850p versus 574p, and Virgin Money is 285p versus 129p.