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Why UK Banks Will Continue To be Hot

 4 min read / 

Global markets have lost circa $3tn in the past few days. The economics do look shaky but markets, as we’ve seen post-2008, often beat to a different drum. From an investment standpoint, however, the same question applies: have markets overshot the economics or have the economics validated the markets?

In this context, overshooting is to the downside so from a long-term perspective, there are companies out there with a tonne of cash trading at considerably fewer multiples than just two weeks ago. Of course, the canary in the coal mine is Brexit, which slammed the pound down to its record two-day collapse, but until the UK triggers Article 50, nothing changes.

In risk-off periods, cyclical stocks take the full force of negative headlines. Banks and homebuilders have taken the brunt of the sell-off, some for rational reasons, and others not so. In this brief article, I want to tackle the question: should investors add bank stocks to their portfolio?

In risk-off moods, banks take the brunt. Why? Because risk-off periods tend to ask questions of the underlying economics, which banks play a pivotal role in supplying credit to households. Markets tend to overshoot on the downside and equities get unfairly treated. The obvious question is when will the stock revert to its mean, or even its high. The problem with that question is when the paradigm changes, the previous high may not even be achievable given the change in market dynamics. To assess a stock’s potential, you need to almost forget the past because in some ways it’s irrelevant what the previous high was. One needs to evaluate its future performance incorporating current conditions.

Given that, what does the future look like for UK banks? The first thing to say is: avoid investment banks because business uncertainty is killing the market, so fewer mergers and capital raisings will take place. Retail banks in the UK look somewhat decent. Low-interest rates for even longer should provide a more solid asset side, although, with rates more likely to go down than up, that clearly isn’t good for the top line growth. Furthermore, if the Brexit fears do start to play out as forecast, unemployment will rise, meaning the banks’ loan books will come under pressure. Add to that, uncertainty over the cost of obtaining the passport, i.e. the access to EU business, is unknown. Those are the main reasons to be cautious on banks, but are they justified? Let’s take them one by one.

Key Issues

Firstly, low rates will kill banks. Low rates have been around since God was a boy. We knew this was going to be the case, even if Brexit didn’t happen. Granted a rate cut is even worse, but in my view, the Bank of England will not cut rates. It will restart QE, which is good for banks because it gives them cheap cash and compresses their corporate bond spreads. Both of which save the bank money. Sure, squeezing their net interest margins is bad which is something to gauge should a rate cut happen.

The second point referred to an increase in non-performing loans. Article 50 hasn’t been triggered as yet. Will it ever be? The UK still wants access to the common market, so it will likely delay the whole process as much possible and given its politicians leading the debate, I wouldn’t be surprised if this process lasted 3+ years. In this scenario, businesses will need to invest because they will be under pressure from their shareholders to place the excess cash. Therefore, from a consumer perspective, this is highly unlikely to cause mass unemployment and people to start defaulting like it’s 2007 all over again. In 2008, the major issue was the payments and settlement system, i.e. banks’ ability to conduct business. Brexit is nothing like that, rather a decrease in confidence and costs. Both of which are uncertain but can change as the market receives solid economic data.

The retail banking industry has been unfairly hit and should an investor have a long-term perspective, UK banks look a decent proposition.

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