Time to buy into banks as headwinds fade

Bad loans, fines, increased legislation and compensation for various scandals including Libor and payment protection insurance resulted in significant losses.

But as Barclays declared it trebled profits in 2016 compared with 2015 and Lloyds results showed how profitable the underlying businesses of banks are when the various costs of the financial crisis no longer act as a drag on profits, should advisers be recommending clients buy banks?

Should advisers push funds that back these financial services giants if the tide is turning for the fortunes of British banks?

According to Adrian Lowcock, investment director of Architas, there are three reasons to like the banking sector at the moment.

He said the headwinds that have hampered the sector are starting to fade as the fines become less frequent and no new scandals arise.

Plus the UK economy has continued to defy expectations and is growing steadily. 

He said a healthy economy is also good news for banks as more people are in employment and are able to pay the interest on their loans. 

As a result non-performing loans remain at low levels.

In addition the gilt curve, which shows the change in yield across gilts with different lengths of maturity, has been steepening since the Bank of England cut interest rates in August. 

Mr Lowcock said this is good news for banks because they tend to borrow money in the short term, where yields are cheaper and lend for the longer term where rates are higher.

In terms of regulation, Mr Lowcock said there are early signs that rules for the banks could have peaked and be easing as US President Donald Trump has already stated he wants to repeal the Dodd-Frank Act in the US. 

Investment banking is a hugely profitable area of finance and an improved regulatory back-drop would be beneficial to investment banking divisions of UK banks as well as US institutions.

So, what are the current risks with investing in financials?

According to Mr Lowock, banks have performed well over the last six months as the market outlook improved at the latter half of the 2016.  

Over this time the FTSE 350 banks index has returned 35.85 per cent, whilst US banks have returned 39 per cent (FTSE USA Banks index). 

More recently there has been a bit of profit taking in the sector.

Mr Lowcock also pointed out banks tend to perform better at the end of the economic cycle. 

There is a risk that rising inflation restricts disposable income and impacts consumer confidence. 

He said this would impact on economic growth and reduce the likelihood of interest rate rises in the UK and the potential rise in bad debt, impacting the future potential profitability of banks.

Another risk is that regulatory reform fails to materialise.

The attempts to repeal financial regulation by Donald Trump is not guaranteed and is likely to be watered down when it passes through the political process in the US. 

But ultimately Mr Lowcock said now is a good time to rethink your client’s holdings in banks.

Investors should be aware that banks tend to be the late bloomers of the economic cycle.Adrian Lowcock

He said: “Investors should be aware that banks tend to be the late bloomers of the economic cycle as they benefit from rising interest rates, stronger economic growth and more confident consumers, but are vulnerable to an economy turning from growth into recession which would hit the profits of banks.

“The share price in banks have already risen in anticipation of future earnings growth, with the P/E ratio (Datastream UK Banks Index) rising from a low of 8.6 after the Brexit vote to 14.5 currently, suggesting shares are no longer cheap.

“Overall we believe banks will benefit from the increased fiscal spending and rising inflation which has already driven up bond yields, although we are less enthusiastic as the rest of market on the extent of the reflation trade.”

In terms of fund ideas to increase your holdings in banks, Mr Lowcock pointed towards Majedie UK Equity.

He said the fund is run by five managers, each individual is responsible for their own section of the funds, who share a core philosophy to be pragmatic and flexible and as such they seek to buy shares with the highest upside potential. 

Mr Lowcock said there is a focus on valuation gap and the fund has targeted deep value sectors of the markets.  

In recent years the themes in the fund have been banks, oil and gas and miners which they started to buy into last year, albeit early.  

The fund currently holds 17 per cent in banks.

Another fund pinpointed by Mr Lowock is JPM US Equity Income.

The income focus of the JPM fund also means this fund is more defensively positioned but is more likely to closely follow the market.  

The focus of the fund is on companies with a durable franchise, not overly leveraged balance sheet, quality of earnings streams and a solid management team.  

The fund holds 12 per cent in US banks.

His final recommendation is Jupiter Financial Opportunities.

The fund targets long term growth by investing in global financials and the managers focus on global themes including ageing populations in developed markets, young populations in Asia and Emerging Markets as well as new technology, data and platforms including robo-advice.  

The fund has a bias towards large-cap liquid names with a focus on quality. This offers greater protection in falling markets but is likely to lag to a rally in the recovering banks.

Laith Khalaf, senior analyst at Hargreaves Lansdown, recommended Jupiter UK Growth as a good fund with high exposure to UK banks for those interested in taking a stake in the fortunes of the sector.

However he said the manager of the fund will change the portfolio from time to time as he sees fit.

In terms of purchasing shares in the banks, he said many are still in recovery mode from the financial crisis with the exception of Lloyds, which he said had reached the light at the end of the tunnel. 

Mr Khalaf said: “Lloyds is therefore an attractive proposition and offers a prospective yield of over 4 per cent so is a good pick for income investors. 

“Barclays might be one to consider for turnaround investors though its share price has already travelled a long way in the last year. 

“Finally RBS might be one for deep value contrarian investors, though there is likely further pain to come in the short term and risks about.”

emma.hughes@ft.com