Ambrose Faulks, co-manager of the Artemis UK Select Fund
It sometimes feels as though investors have given up on the UK’s banks. Indeed, any fund manager with less than 15 years' experience in the UK market will have never seen banks outperform for more than a few quarters. Bank equity has over this time provided a volatile ride, with at times unwelcome surprises along the way. The only consistency being the long-term downward trend in performance. Ignoring the sector, and not owning it has on the whole been a profitable strategy. The headwinds for the sector since the credit crunch are well known:
- Restructuring, conduct (majority PPI claims) and litigation costs – have in aggregate seen the profits that the UK businesses of Barclays, Natwest and Lloyds have produced over the last 10 years wiped out.
- Falling interest rates – banks traditionally make money by taking deposits (the highest-quality form being current accounts) and lending them back to borrowers at higher rates and for a longer duration. They can also take their long-term, non-interest-bearing deposits (and equity) and hedge them using interest-rate swaps. The aggregate spread of these loans and deposits forms the banks’ net interest margin (‘NIM’). A long period of very low interest rates has compressed this ‘NIM’ and made it a lot tougher for the banks to make money on their loans.
- Capital – post the financial crisis, the Bank of England has required the sector to hold more capital. Today the UK now has one of the best-capitalised banking systems – with roughly three times more capital than it did before the global financial crisis. The build in capital has limited cash distributions to shareholders.
Looking forward we believe there are reasons for more optimism, as these headwinds either abate, or reverse. Litigation and conduct charges are likely to remain an on-going cost to the sector, although we expect them to be significantly smaller in future. On the capital front, the rebuilding has been completed, a return to the dividend list and announcement of share buyback programmes from the five largest UK quoted banks are evidence for this. Lastly the interest rate cycle is turning – we believe this will benefit the profits of the banks, and in time the multiple they trade on. Together these factors represent a sea change in prospects for a long-unloved sector.
What could go wrong?
The inherent leverage on the banks’ balance sheets, combined with their loan exposure to consumers and corporations by definition makes them highly geared into the fortunes of the UK economy. It is clear that over the last few weeks concerns around the war in Ukraine and the much publicised ‘cost of living crisis’ has seen sentiment on the outlook for the UK economy become increasingly pessimistic. This in turn has weighed on bank shares.
Many commentators are talking up the prospect of stagflation – low economic growth in a high-inflation environment. We would note that of the headline inflation of around 7% today, roughly 3% is coming from energy prices. This is likely to drop out once recent rises start to annualise. Given the enormous surplus of excess deposits that built up during the pandemic (UK consumers added £225bn to their banks accounts during the pandemic) and the propensity for Anglo Saxon customers to borrow, we maintain that whilst this burst of inflation is unfortunate, it can be bridged by the UK consumer through savings, higher earnings and in some cases more borrowing.
And as for loans? There are two key points to make about loans going ‘bad’. Firstly, if loans do go sour – we must ask what sort of collateral they are secured against – loans to values of housing look sound, particularly given the rise in house prices over the last two years. In consumer unsecured credit, banks enter this year with materially smaller loan books as consumers have spent the last two years paying off their balances at a record pace. The opposite trend to what would be seen in a typical consumer led boom to bust recession.