Investing in UK bank stocks may not be that risky

The prognosis for the UK banking sector has clearly become gloomier of late. 

This week marks the beginning of the half-year results season and the key talking points among market participants are slowing loan growth, declining net interest margins, and gradually deteriorating asset quality. This article considers the specific factors underpinning investors’ expectations and explores why it does not necessarily follow that one should altogether avoid investing in UK banks at this juncture.

Banks are leveraged exposures to the economies in which they operate and it is therefore important to consider the implications of the macroeconomic backdrop.

Recent UK economic data has painted a disappointing picture in terms of banks’ earnings outlook and asset quality profiles. While the second quarter UK GDP growth rate is likely to come in higher than the 0.2% reported for the first quarter, overall growth is clearly on a downward trajectory. The impact of Brexit discussions also clearly plays a role in this context as consumers rein in their expenditure in response to a more uncertain economic outlook and, perhaps more importantly, as businesses defer capital investment programmes and/or trim costs – which also ultimately impacts negatively on the consumer.

Weaker economic conditions are unhelpful for loan demand. Indeed, we have observed a recent material slowdown in mortgage lending, consumer credit growth looks set to slow, and while corporate loan growth has remained relatively resilient to date, demand remains subdued. Lending volumes will be a key focus for investors in the upcoming UK banks results season.

Losses on consumer lending had been falling since 2009 but have recently begun to increase. This is unsurprising in the context of the rapid pace of consumer credit growth, which has been north of 10% per annum in recent years — though non-bank lenders, especially in the car finance domain, have been responsible for a substantial proportion of this growth. Rising inflation that is not matched by earnings growth is squeezing the consumer with household debt/GDP climbing towards precarious levels.

This does not bode well for bank provisioning levels. Any rise in unemployment owing to weaker economic conditions would also be unhelpful in this vein. That said, UK banks have tightened their mortgage lending criteria significantly since the global financial crisis partly in response to the Bank of England’s sensible measures to prescribe minimum underwriting standards and stress-testing requirements.

While the prognosis for the sector is poor, bank share prices have sold off significantly and already factor in material downside. Contrary to conventional wisdom, there is evidence to suggest that there is a disconnect between economic growth and share prices — with stock prices typically moving well ahead of reported economic data. In fact, we see some UK banks as attractively priced in the context of the recent de-rating. In particular, the valuations of some of the newer ‘challenger banks’, which exhibit higher capital levels and lower risk loan books than certain mainstream banks, appear compelling following a bout of overselling.

John Cronin is head of UK banks research at Goodbody Stockbrokers

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