Why the big lenders banks remain a bankable indicator for the wider health of markets

One of this column’s key themes for 2017 is the health of UK banks and why this is important to any investors with exposure to the UK equity market.

The Big five quoted names – Barclays, HSBC, Lloyds, Royal Bank of Scotland and Standard Chartered – represent around 15% of aggregate FTSE 100 pre-tax profit and dividend payments, according to analysts’ consensus forecasts for 2017, with HSBC and Lloyds both in the list of 10 largest cash distributors.

The good news is the sector has started the year well in the UK, with a 5.7% gain. This easily outstrips the FTSE All-Share.

Banks’ top-10 sector performance ranking is unusual, looking at the last decade

2017 performance to date
1 Mining 12.0%
2 Industrial Engineering 9.4%
3 General Industrials 9.1%
4 Industrial Metals 8.9%
5 Tobacco 7.2%
6 Electricals & Electronics 6.9%
7 Forestry & Paper 6.4%
8 Beverages 5.5%
9 Technology Hardware 5.3%
10 Banks 5.2%
FTSE All-Share 1.1%
30 Oil Equipment -1.7%
31 Leisure Goods -1.8%
32 Electricity -2.9%
33 Real Estate Inv. Trusts -3.2%
34 Industrial Transport -3.8%
35 Mobile Telecoms -4.4%
36 General Retailers -5.7%
37 Oil & Gas Producers -6.3%
38 Food Producers -7.0%
39 Fixed Line Telecoms -14.9%

Source: Thomson Reuters Datastream

It is also enough to leave the banks sector ranked tenth out of the 39 industrial groupings which constitute that broad benchmark.

Banks sector is off to a good start in the UK in 2017

Banks sector is off to a good start in the UK in 2017

Source: Thomson Reuters Datastream

With the exception of the false dawn in 2012, banks have not ended a year in the top 10 since 2001, and three factors have underpinned this promising start to the year, helping to overshadow concerns over what Brexit might mean once Article 50 is triggered:

  • First, President Trump’s promise to roll back deregulation in the USA.
  • Second, broader hopes for improved global growth, a trend which has been gathering since last summer and been fostered by the new President’s promised programme of tax cuts, infrastructure spending and also deregulation.
  • Finally, a steepening in the yield curve, as discussed in last week’s column. In theory this makes it easier for banks to borrow at the short end of the curve at a lower rate and lend out at the long end at a higher rate, pocketing the difference as their net interest margin.

UK banks are responding favourably to a steeper yield curve

UK banks are responding favourably to a steeper yield curve

Source: Thomson Reuters Datastream

Eagle-eyed investors will note that the UK yield-curve has just flattened off a little in the past week or so, as the gap between 2-year and 10-year Gilt yields has come in from around 1.3% to 1.15%. That leaves the differential exactly where it was a year ago, while the Banks FTSE All-Share sector is up by 44% over the past 12 months, so if the yield curve rolls over then investors who are bullish on the banks specifically or markets more generally may need to pay attention, as it could be a warning sign.

Equally, any fresh steepening could conceivably give the sector further impetus and potentially help with the wider UK market, given the importance of the big five banking stocks to overall earnings and dividends.

Should investors wish to home in on the sector specifically the good news is there is good selection of funds that will help them do so, in exchange for a fee. Most, however, take a global rather than a UK-centric or regional view and cover the full range of financial services and not just banks, so insurers and asset gatherers will be in there as well.

Those investors who prefer open-ended funds or exchange-traded funds (ETFs) are better served in this area than those who like investment trusts.

Best performing specialist financials OEICs over the past five years

OEIC Fund size £ million Annualised 5-yr performance 12-month Yield Ongoing charges  Morningstar rating 
Polar Capital Global Insurance I (Acc) 707.4 20.4% n/a 0.90% *****
Fidelity Global Financial Services W (Acc) GBP 997.9 15.6% n/a 1.07% ****
Guinness Global Money Managers Fund X 4.9 15.5% n/a 1.24% ***
AXA Framlington Financial Z GBP (Acc) 45.6 14.0% 1.90% 0.87% ***
Jupiter International Financials I (Acc) 38.3 13.8% 1.37% 1.13% ****

Source: Morningstar, for the Sector Equity Financial Services category.
Where more than one class of fund features only the best performer is listed.

The sole specialist financials investment company

Investment company Market cap (£m) Annualised 5-yr performance *  Dividend Yield Ongoing charges ** Discount to NAV Gearing Morningstar rating
Polar Capital Global Financials 231.1 n/a 2.6% 1.06% -1.6% 0% ****

Source: Morningstar, The Association of Investment Companies, for the Sector Specialist: Financials category
* Share price. ** Includes performance fee. Trust launched in July 2013.

Best performing specialist financials ETFs over the past five years

Exchange Traded Fund Market cap (£m) Annualised 5-yr performance Dividend yield Ongoing charges Morningstar rating  Replication method
Source Financials S&P US Select Sector UCITS ETF (USD) 582.5 21.71% n/a 0.30% ***** Synthetic
Lyxor MSCI World Financials TR UCITS ETF C-USD (USD) 34.1 15.65% n/a 40.00% **** Synthetic
Amundi ETF MSCI Europe Banks UCITS ETF (GBP) 56.5 6.59% n/a 0.25% ** Synthetic
db x-trackers Stoxx Europe 600 Banks UCITS ETF 1C (GBP) 132.2 5.39% n/a 0.30% ** Synthetic
Source STOXX Europe 600 Optimised Banks UCITS ETF (EUR) 44.8 5.38% n/a 0.30% ** Synthetic

Source: Morningstar, for the Sector Equity Financial Services category.
Where more than one class of fund features only the best performer is listed.

Rocking all over the world

It is not just the UK where banks are doing well. In the USA, the S&P 500 Banks index is advancing smartly and, in a further sign of the lenders’ apparent health, the Philadelphia KBW index of leading regional banks is also on the march.

US large and small-cap banks continue to march higher

US large and small-cap banks continue to march higher

Source: Thomson Reuters Datastream

The combination of improved US economic growth, a deregulation drive from President Trump and a steeper yield curve as the Federal Reserve inches its way toward a third interest rate increase are all contributing here.

Japanese economic momentum may remain modest, as evidenced by 2016’s meagre 1.0% increase in GDP, but banks are doing well on the Tokyo market, judging by the Topix banks index. Markets are looking at the Bank of Japan’s zero interest rate policy (ZIRP) here and pondering whether the monetary authority is going to back away from both this and its ¥80-trillion-a-year Quantitative Easing (QE) scheme if and when GDP growth accelerates.

Japanese bank shares are also rising

Japanese bank shares are also rising

Source: Thomson Reuters Datastream

The picture is a little less clear in Europe. The Stoxx Europe banks index is up by 31% over the past 12 months, in euro terms, although this does lag local-currency capital returns of 52%, 45% and 35% from the S&P 500, FTSE All-Share and Topix indices respectively.

The problem lies with Southern Europe – Italy’s FTSE MIB banks index is down by 4% on where it was 12 months ago, for example and the Milan exchange must be watched closely.

While the in’s and out’s of individual Italian banks may constitute more detail than investors need, it is worth keeping an eye on the bigger picture.

UniCredit’s €13 billion rights issue and balance sheet clean-up is particularly important. Firstly because it is an attempt to put a leading bank on a proper footing and secondly because it hints at just how dangers the Italian situation really is.

As part of its balance sheet polishing process, UniCredit is writing down the value of its investment in Atlante I, the “bad bank” set up by Rome’s then Prime Minister Matteo Renzi last year with €5 billion of capital with a goal to shoring up the Italian banking industry. The degree of write-down is not clear but another key investor in Atlante I, the rival Intesa SaoPaolo bank, has booked a 33% haircut on its stake.

This is worrying for two reasons.

  • First, these book losses are coming less than a year after the establishment of Atlante I, to suggest the problems in the Italian banking system are greater than thought
  • Second, this in turn suggests that neither Atlante I’s €5 billion capital pool, nor the €25 billion allocated to its successor, Atlante II, will be in any way sufficient to adequately prop up the system. European Central Bank analysis which shows Italy’s 14 biggest banks had non-performing loans of €284.4 billion on their balance sheets as of September (down just €1.6 billion from June) so even the combined €25 billion Atlante rescue fund is assuming truly heroic recovery rates.

European banking stocks are trying to shrug off Italian woes

European banking stocks are trying to shrug off Italian woes

Source: Thomson Reuters Datastream

Best of British

Attention must therefore still be paid to Italy, while the Greek sovereign debt problem continues to bubble away in the background, as Athens struggles to meet a €7 billion bail-out repayment due this coming July.

Even if their strong share price showing looks like a good sign for the wider equity markets and the global economy, there is therefore no room for complacency when it comes to the banks, as shows by events in Southern Europe. Moreover, the positive response to a steepening yield curve is a relatively new phenomenon.

As the chart below shows, the FTSE All-Share Banks index used to move inversely to the yield curve until around 2008-09, as a steeper curve was then seen as a sign that interest rates rises were coming and the UK economy was therefore set to cool (with potential implications for bad loan losses). The influence of NIRP, ZIRP and QE can be seen here as the Bank of England has done all it can to hold interest rates down and flatten the yield curve, at least at the very short end.

UK banks stocks used to fight shy of a steeper yield curve, at least until 2008-09

UK banks stocks used to fight shy of a steeper yield curve, at least until 2008-09

Source: Thomson Reuters Datastream

Perhaps markets are welcoming an end to this manipulation of the cost of money but given the amount of Government, corporate and consumer debt sloshing around the system they must be carefully about what they wish for when it comes to increases in interest rates.

The next test

Besides the risk of fresh wobbles in Europe, the imponderable timetable of UK interest rate increases (and any impact on the mortgage market in particular), British banks must also confront the prospect of Brexit, and whether equivalence rules will be sufficient to compensate for any potential loss of passporting rights for products and services into the EU.

A more immediate test for the UK’s Big Five, however, rests in the form of the imminent full-year reporting season, as each of Barclays, HSBC, Lloyds, RBS and Standard Chartered are due to publish their figures in the week of 20-24 February.

Again, without wishing to bombard anyone with too much detail, there are four key areas to watch here.

  • First, loan growth and whether it will continue to accelerate – aggregate loans to customers across the Big Five grew year-on-year by 6.6% in Q3 (after 5.5% in Q2, ending a long period of shrinkage). This could be a good sign for the broader economy, not to mention the banks’ earning power as the yield curve steepens and net interest margins rise.

UK banks are finally demonstrating loan growth on an aggregate basis

UK banks are finally demonstrating loan growth on an aggregate basis

Source: Barclays, HSBC, Lloyds, RBS and Standard Chartered accounts

  • Second, the trend in bad loan write-offs (also known as impairments) totalled £2 billion in Q3, unchanged on Q2. It would be good to see this come down to help profits and the banks’ overall health.

UK banks are still piling up impairment charges

UK banks are still piling up impairment charges

Source: Barclays, HSBC, Lloyds, RBS and Standard Chartered accounts

  • Third, litigation and conduct fine payments, which came to £2.7 billion in Q3 and £5.5 billion in the first nine months of the year across the Big Five (against £1.6 billion and £7.6 billion a year ago). It is to be hoped they are now nearing the end of PPI and looking to keep their noses clean as this is pretty much pure cash outflow – and the £5.5 billion in fines paid this year and the £58 billion paid since 2011 compare to forecast dividend payments of £10.8 billion for 2016.

UK banks would be much more profitable if conduct and litigation fines started to fall

UK banks would be much more profitable if conduct and litigation fines started to fall

Source: Barclays, HSBC, Lloyds, RBS and Standard Chartered accounts

  • Finally, the dividends themselves. HSBC is forecast to pay an unchanged dividend of $0.51, RBS will pay nothing, Barclays and Standard Chartered have forecast cuts and Lloyds is expected to increase its total dividend from 2.25p (excluding last year’s 0.5p special) to 2.85p.

It is these figures which mean banks are expected to pay around 15% of total FTSE 100 dividends in 2016 and again in 2017, when Lloyds is expected to generate 6% of the analysts’ consensus forecast FTSE 100 dividend increase on its own.

Such numbers, if met, would potentially underpin Lloyds’ appeal to income investors, as a 3.47p dividend (on a 66p share) price equates to a 5.2% yield. The problem here is dividend forecasts for Lloyds have dribbled relentlessly lower, as impairment charges, restructuring costs and PPI compensation have weighed on the profit and loss account.

Dividend forecasts for Lloyds have crept consistently lower

Lloyds dividend per share forecast (pence) Dec-14 Mar-15 Jun-15 Sep-15 Dec-15 Mar-16 Jun-16 Sep-16 Dec-16 Feb-17
2014 1.06 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.75
2015 2.9 2.84 2.76 2.51 2.39 2.25 2.25 2.25 2.25 2.25
2016 4.12 4.24 3.87 3.7 4.41 4.38 3.18 3.12 2.85
2017 5.2 5.09 3.39 3.67 3.47
2018 3.95

Source: Digital Look, consensus analysts’ forecasts

If Lloyds can start to shake off these legacy issues then a blossoming profit and loss account would give a better foundation to those long-awaited increases in dividends – remember that even the forecast 2018 figure of 3.95p a share compares to the 35.9p just before the Great Financial Crisis.

Russ Mould, AJ Bell Investment Director