UK bank bargains beckon as rate rises set to boost results

Our City expert reports opportunities in the banking sector as shares fail to respond to profit-enhancing interest rate rises.

The refusal of banking sector valuations to respond to the oxygen of higher interest rates will be tested this week when Lloyds Banking Group (LSE:LLOY) and NatWest Group (LSE:NWG) report quarterly results.

It’s been a dismal start to the year for shares in major lenders, with Lloyds and other London-listed stocks lower even though rates are finally moving off their floor following 14 years at near to record low levels.

The possibility of earnings revisions based on margin-enhancing rates of 2% or 3% has not been enough to reinvigorate shares: the European banking sector is still on a lowly eight times forward earnings and the UK is even worse at 7.4 times.

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Analysts at Bank of America (BoA) say: “Somehow the market has moved straight to worrying about too many rate hikes. Opportunity beckons.”

Stagflation fears and the threat of rising defaults have been blamed for the market malaise, but BoA says its analysis going back 60 years shows that banks tend to prosper in a higher-inflation environment: “It's zero rates they really couldn't manage.”

The bank says non-performing loans are at long-term lows and down 73% since 2015, while Covid-era government guarantees on business loans should have reduced tail risk.

The bank also notes that balance sheets are stronger than ever to absorb sovereign debt risks, on which it believes the upside will be more than offset by higher revenues.

Bank of America’s three favoured European stocks for a higher rates era are NatWest, as well as BNP (EURONEXT:BNP) and Allied Irish Banks. UBS also opts for NatWest as its top domestic bank, one of seven UK “buy” recommendations in a note published at the end of last week.

NatWest, which publishes its trading update on Friday, is seen by UBS as having a 33% upside to 200p. Lloyds Banking Group has a price target of 58p, compared with 46p last Friday.

Both stocks traded higher today after UBS, Banco Santander SA (LSE:BNC) and HSBC Holdings (LSE:HSBA) posted encouraging first-quarter results. Despite increasing its loan loss provisions due to the more uncertain outlook, Santander lifted pre-tax profits by 9.4% to €4.17 billion (£3.5 billion).

Chief executive Ana Botin says credit quality remains solid and has stuck by guidance for mid single-digital revenues growth and a return on tangible equity above 13%.

Looking across the sector, UBS analyst Jason Napier believes that a rates cycle of around 250 basis points would be enough, without factoring in cost inflation, to increase average net interest income and pre-provision profit by roughly 30% and 50% respectively.

He adds: “Tail risks around the economy remain – particularly if energy embargoes lead to a shortage of energy – but we think credit risks in bank balance sheets are exaggerated in current valuations if our base case growth, inflation and unemployment forecasts prove roughly right.”

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Napier’s recommendations include a big upside on his price target for Barclays (LSE:BARC)​​​​​​​ to 260p, while Virgin Money UK (LSE:VMUK) is valued a third higher at 230p.

The FTSE 250-listed lender is not due to report its half-year results until next week, but Deutsche Bank’s analyst Robert Noble sees the potential for a positive surprise.

He says the City’s net interest income expectations still seem low, particularly as Virgin recently increased its margin guidance to 175 basis points based on no further rate hikes.

Noble is 5% above consensus on a pre-provision basis and 10% above post-provisions. He adds: “Unemployment tends to drive asset quality the most, and Virgin already assumes a base case 4.6% UK unemployment rate in 2022 with unemployment in the UK currently 3.8% and falling.”