Someone in the market has UK banks totally wrong

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Nobody really knows whether Chancellor of the Exchequer Kwasi Kwarteng is friend or foe to British banks. What is obvious right now: Someone is wrong.

Investors haven’t liked shares of Britain’s biggest lenders much all year and sold them enthusiastically in the market meltdown sparked by the country’s biggest tax cut program in five decades, which was announced on Friday.

But brokers have steadily raised profit forecasts for Barclays Plc, HSBC Holdings Plc, Lloyds Banking Group Plc, NatWest Group Plc and many smaller rivals throughout the year. The argument for optimism right now is simple: higher interest rates boost incomes, and energy subsidies protect borrowers, the economy, and therefore banks. Jefferies’ Joseph Dickerson estimates capping energy prices will save UK banks 2% of national profits next year by reducing defaults on consumer loans.

After Friday’s budget, Kwarteng told finance chiefs his policies would generate growth and promised them a wave of deregulation at a meeting on Tuesday.

Meanwhile, many UK consumers, like their US counterparts, are being cushioned by more than £200bn ($215bn) of excess savings built up during the Covid-19 pandemic, Office data shows. for National Statistics. Household debt-to-income ratios have also barely changed in eight years and remain well below their 2008 peak, according to the Bank of England. Loans to households seem low risk and increasingly profitable.

So what about falling stock prices? There is undoubtedly a further rise in the risk premia attached to the UK, which simply means that investors are demanding a higher return to hold UK assets due to the economic and political uncertainty the country continues to experience. generate. Shares of UK-focused banks like Lloyds have suffered a Brexit discount since the 2016 vote to leave the European Union. Lloyds and its also UK-focused rival NatWest have fallen 9% and 15% respectively since the start of last week, much worse than the more international Barclays or HSBC. All but HSBC are down for the year, but the four banks’ 2022 earnings per share forecast has risen from 13% to nearly 40% over the year.

Part of this may just be passing fear over Kwarteng’s seemingly cavalier approach to Britain’s long-term financial health: big spending commitments as well as tax cuts and few details on how these might balance out. But the resulting sharp rise in UK government borrowing costs and the pound’s sickly reaction illustrate the potential for real economic risks: higher inflation via import prices, rising interest rates that dampen demand and a potential increase in unemployment as a result. Unemployment is bad news for lenders.

Investors could also simply try to reassess the cost of equity they should apply to banks, according to Andrew Coombs, analyst at Citigroup Inc. This is the minimum level of return an investor should expect and it is generally estimated at around 10% for banks. . Coombs currently applies a cost of equity of 11-12% for UK banks, in line with other European banks but higher than the wider UK stock market.

Apart from HSBC, the major UK banks are trading at a much higher implied cost of equity, based on a simple model using forecast return on equity and current valuations in terms of price to book value. Lloyds and NatWest both have an implied cost of equity of around 15%, while Barclays is at 18%, although this is likely due to its riskier and more volatile investment banking business.

The alternative, of course, is that the earnings and return forecasts are too high: it is the brokers who are overly optimistic, not the investors who are pessimistic.

There are many things that could hurt banks, especially disposable income. The energy price cap will protect consumers to some extent, but still leave them paying bills about twice as high as last year. Rising interest rates will also affect mortgage costs: the vast majority of borrowers have loans with fixed rates for up to five years, but around a sixth of them are due for reassessment over the next year at interest rates that can range from two to three times higher. Moreover, the share of households whose debt service costs represent more than 40% of their income – indicating a higher risk of repayment problems in times of turmoil – had already increased from a low level. , according to the Bank of England.

The government wanted to stimulate spending and growth with its income tax cuts, but it gave half the benefits to the top 5% and two-thirds to the top 20%. Britain’s wealthy are most likely sitting on the biggest chunk of excess savings of over £200billion set aside during the pandemic. In other words, the rich are already not spending the money they have, so giving them more money seems unlikely to stimulate the economy.

High rates, low growth and inflation would make the economic outlook bleak. Add to that government spending cuts to balance its budget or rising unemployment, or both, and the outlook for loan losses from UK lenders will worsen.

Long-term decisions are tough amid the noise-like market chaos of the past few days: Some mortgage lenders have stopped offering new loans while they wait to see where their own funding rates stabilize. But I suspect domestic earnings forecasts for UK banks are going to be reduced in the coming months. Investors are more right than analysts.

More from Bloomberg Opinion:

• Can Kwasi Kwarteng recover his credibility? : Raphael and Hanson

• Brexiteers want a piece of the Bank of England: Paul J. Davies

• The gap continues to widen between the United States and Europe: Lionel Laurent

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Paul J. Davies is a Bloomberg Opinion columnist covering banking and finance. Previously, he was a reporter for the Wall Street Journal and the Financial Times.

More stories like this are available at bloomberg.com/opinion

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