Stockwatch: how Brexit trade deals could affect these bank stocks

Positive news on Brexit talks could start to edge out Covid-19 updates, but is that good or bad for banks? 

The signs of more Brexit trade deals are getting stronger. 

As Boris Johnson and Leo Varadkar defied sceptics to strike a deal over the Northern Irish border dilemma, the UK Prime Minister and European Commission President Ursula von der Leyen are reportedly poised to push a deal over the line later this week. A pact would then be signed off early next week allowing legislation to be passed by the European Parliament in late December.  

Bank stocks have started the week forging ahead, given their overall sensitivity to the UK economy. The last fortnight’s strength has chiefly been driven by good news around Covid-19 vaccines, but I suspect their essential good news element is now known and the Brexit story will take over again.  

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Yes, it will still be a difficult winter coping with the virus. But financial markets now assume it will be dealt with over the medium term, especially as vaccines’ roll-out coincides with spring/summer.

Even if the real-world experience shows less than about 90% efficacy in trials, it should be plenty better than flu vaccines’ typical 40% to 60% efficacy. Moreover, it appears the NHS has secured enough supplies of the AstraZeneca/Pfizer shots to amply cover the UK population through 2021. Even if there are dissenters, the R reproductive number should get below 1.0 and Covid-19 would die down.  

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Amid the recent gloom it has been easy to lose sight of how international investors have avoided the UK – apart from selective, opportunistic takeovers – for some years while the fiasco of implementing Brexit has dragged on. 

Lately, a strong majority Johnson government has appeared uncompromising towards the EU, which similarly looked dug in. I suspect the mentality behind international finance is more attuned to the free trade arrangements the EU symbolises rather than the sovereignty principle that tipped the 2016 referendum. 

Jaundice set in among these investors and UK equities become rated lower than most, but you can see from the way sterling and bank shares are twitching up that sentiment is changing. 

The domestic orientation of mid-250 stocks also makes them a potential prime beneficiary.  

Lloyds Banking Group as the popular choice  

With some 95% of its assets in the UK, Lloyds Banking Group (LSE:LLOY) is understandably a choice stock for taking a view on the economy. At around 38p it has risen nearly 40% this month. But unlike many stocks that have roared ahead it is only at the upper end of a sideways consolidation that saw a similar price-high in late March and June. This compares broadly with a 50p to 70p range over the previous two years. 

If the group – which consists also of Bank of Scotland, Halifax and Scottish Widows – can recover net profit to £2.5 billion in 2021 after a lurch down from £2.9 billion to £950 million this year, its forward price-to-earnings (PE) ratio would be 11x. Consensus also expects a 1.6p dividend in respect of 2021, implying a material 4.2% yield.  

I would exercise care towards such projections and question whether the chart de-rating is to an extent justified by the Bank of England which is purposely keeping interest/mortgage rates very low. 

A conservative financial view would be that bank stocks have been a poor long-term hold since the 2008 crisis – apart from speculative rallies – because the low interest rate regime central banks have adopted makes it harder for lending banks to prosper. 

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In late 2019 for example, promoters of Lloyds’ shares argued the bank would enjoy a kick-start of growth from the new government’s “levelling up” agenda of financial support to poorer areas. 

But that does not necessarily mean increased demand for loans, and anyway Covid-19 spending has massively disrupted government plans. The Tories will have to deliver to some extent on their 2019 electoral promises, but if taxation is raised in the medium to longer term it could mitigate any regional stimulus. 

So, I would not assume domestic bank shares are a long-term hold if Brexit trade talks deliver progress. I imagine the successful trade they currently are would continue, but in due course hit a moment of truth: how is interest rate destruction consistent with banks’ prosperity? 

In fairness, and to date, Lloyds’ return on equity has averaged 5% over the last five years. This compares with 1.75% for rival Barclays (LSE:BARC) and -1.6% for NatWest (LSE:NWG), while HSBC (LSE:HSBA) is slightly ahead on 5.2%. But this is still past performance, and the pandemic has ground rates down further since. 

A short-term trading view is not really my style but if you reckon a trade deal can be reached with the EU – avoiding extra tariffs from 2021 – then Lloyds remains a ‘buy’.  

Metro Bank as the more speculative play 

In chart terms this relatively small cap minnow Metro Bank (LSE:MTRO) is capitalised around £200 million versus £24.5 billion for Lloyds, and it has a record chiefly of losses versus the black horse’s established earning power (see the tables). 

The challenger bank concept does have a role, and Metro rates well for customer service. But under a flamboyant founder-chairman it ran into problems. These included over-size branches in expensive locations and an early 2019 scandal where a portfolio of commercial loans – about 10% of its loan book - were classified incorrectly and so the bank held insufficient capital. 

This triggered a 75% share price fall over four months and the stock becoming one of the most shorted on the London market.

Thus, a reason for its currently being lively on the upside – more than doubling from 58p to 125p this month – is propensity for short traders to feel squeezed. Around 6.9% of Metro’s issued share capital remains out on loan, with Odey Asset Management the chief protagonist responsible for 4.4% as yet with no sign of trimming. 

Sometimes the Odey team makes good calls on the short side but they are not immune to conviction becoming dogma.

Interestingly, on 5 November Metro’s CEO since last February bought 1.5 million shares at 59.3p – a near £900,000 outlay – and the chairman (effective from 1 November) bought 30,000 shares at 58.9p. This was around an all-time Covid-19 related low, the stock having initially dropped from around 200p to 78p last February/March.

The purchases came after a likely restricted period ahead of a 5 November third quarter 2020 update which suggested little change during the period. That said, net loans edged up 2% to £15.1 billion “driven by continuing government supported business lending”. Year on year, deposits rose 10% and the loan-to-deposit ratio eased from 105% to 97%, reflecting a more cautious environment.  

More positively, the update cited progress delivering on strategic priorities set out with last February’s preliminary results: robust capital and liquidity; strong asset quality; simple balance sheet; leading customer service; customer account growth and a return on tangible equity in excess of 8.5% by 2024. If achieved that would put Metro at the top of the domestic banking sector. 

The new CEO is a bit of an unknown entity but was most recently chief operating officer of Butterfield Bank. This is headquartered in Bermuda and providing specialised banking, asset management and custody services in offshore financial centres, as well as Switzerland, Singapore and the UK. 

Doubtless one of his motivations was net tangible assets per share of 948p shown at the end-June interim balance sheet date.

It probably remains a long haul to achieve the solid PE multiple that Lloyds enjoys – a net loss of £67 million being the consensus expectation for 2021. However, the long-term case for Lloyds does not include a margin of safety, while interest rates seem unlikely to recover much, if at all.

 Also notable in terms of stake positioning is Goldman Sachs having just raised its stake in Metro from 2.6% to 10.2% with the help of contracts for difference and financial swaps. Spruce House Partnership – a New York-based investor – holds 9%.

It will be interesting to see how this stand-off between Odey and Goldman – short versus long – plays out. 

If Metro can achieve anywhere near an 8.5% return on net tangible assets, then even after doubling its stock remains a ‘buy’ at 125p - if manifestly speculative. 

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.