Chris Kinder, Portfolio Manager of the Threadneedle UK Fund, outlines why despite UK banks returning to favour he remains wary of the sector.
Profits and margins are up, impairment losses down and dividends are coming back: almost 10 years on from the global financial crisis, UK bank stocks have been tentatively returning to favour. With balance sheets largely repaired and excess capital being paid out to shareholders, a growing band of investors are deciding to give banks a second look.
However, our long-standing negative view on most UK banks remains unchanged. Indeed, it has been reinforced by the superficially positive news that has been emanating from the UK banking sector.
In our view, while UK banks have somewhat healed, they are currently overearning and with impairments expected to rise from multi-decade low levels, we feel that profitability could fall from current levels.
Peak margins
Banks around the world have spent much of the past decade trying to restore credibility following the trauma of the global financial crisis - with some success.
In a tougher regulatory environment, businesses have been restructured and balance sheets rebuilt. Lloyds Banking Group and Royal Bank of Scotland (RBS),* both of which had to be bailed out by the UK government, are currently delivering high margins with impairment losses well below multi-cycle lows.
Yet, this doesn't give us confidence. In our view, margins, having peaked, look likely to trend down. Meanwhile, impairment losses can only trend up from such a low base. We do not feel we are about to witness another banking crisis, simply that the earnings on which banks are valued today feel vulnerable.
Bank valuations
The act of accurately valuing banks is already made difficult by the way that capital is calculated and quantified in the UK. We believe that the system gives a false picture of the health of banks as it treats mortgages as if they are of little risk.
Investing in banks is inherently risky because they are so leveraged. In our view, in the event of a housing slowdown and house price correction there would not be enough bank capital in the system to absorb mortgage losses. The risk of mortgage impairments rising, and its failure to be reflected in capital calculations, is one that investors should be wary of.
Lingering costs
Even though capital reserves have improved, banks have not been able to retain earnings as they should because of huge restructuring charges and compensation payments for past scandals.
Lloyds, now fully back in private ownership, has had to earmark more than £18 billion for PPI compensation, setting aside another £350 million in the first quarter of this year [2017].1 while RBS, was recently ordered to pay $5.5 billion to US regulators following a probe into the sale of mortgage-backed securities.2
Too early for interest rate rise
UK banks might possibly benefit from higher interest rates, which could bolster their margins, but I fear that the economy does not look ready for interest rates to rise with any significance.
The risk of an inflation shock could force the Bank of England to tighten earlier than it would prefer. However, our view is that such a scenario is unlikely and unwelcome. We believe that the pick-up in prices seen over the past year is primarily a one-off adjustment to weak sterling, and that inflation may well be in the process of peaking. With rates staying lower for longer, banks' net interest margins and earnings are likely to come under considerable pressure.
However, opportunities in financials still to be found
In our opinion there are better opportunities to be found elsewhere in the financial sector. Opportunities that offer the potential for solid long-term, risk-adjusted returns.
We are overweight insurance, for example and in ‘other financials', a broad church that includes asset managers and real estate investment trusts (REITs). Our view was that, following the Brexit vote, property prices would not correct to anything like the degree that bears were suggesting and we have been proved partly right; property has held up well due to the influx of international investors and the fact that rent rolls are stable. However, this more bullish-than-expected outcome has yet to be reflected in the price of REITs.
- Financial Times: Lloyds Bank profits miss estimates after further rise in PPI costs, 27 July 2017.
- Financial Times: RBS to pay $5.5bn to US authorities over mortgage-backed securities probe, 12 July 2017.
* The mention of any specific shares should not be taken as a recommendation to deal.
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Past performance is not a guide to future performance. Your capital is at risk. Threadneedle Investment Funds ICVC ("TIF") is an open-ended investment companies structured as an umbrella company, incorporated in England and Wales, authorised and regulated in the UK by the Financial Conduct Authority (FCA) as a UCITS scheme. The mention of any specific shares or bonds should not be taken as a recommendation to deal. This material is for information only and does not constitute an offer or solicitation of an order to buy or sell any securities or other financial instruments, or to provide investment advice or services. Any opinions expressed are made as at the date of publication but are subject to change without notice and should not be seen as investment advice. Information obtained from external sources is believed to be reliable but its accuracy or completeness cannot be guaranteed. Columbia Threadneedle Investments is not responsible for meeting any regulatory requirements that may arise from using the information herein. Threadneedle Investment Services Limited. Registered in England and Wales, Registered No. 3701768, Cannon Place, 78 Cannon Street London EC4N 6AG, United Kingdom. Authorised and regulated in the UK by the Financial Conduct Authority Columbia Threadneedle Investments is the global brand name of the Columbia and Threadneedle group of companies.
