The UK’s biggest bank stocks – time to take a look?

2023 was a year of changing trends.

Banks benefitted from interest rate hikes at the start of the year and it’s one of the main reasons year-over-year profit comparisons look so frothy.

However, as we moved through the year, pressure mounted to pass rate hikes on to consumers, the mortgage market was a headwind and performance started to drop from its highs.

Return on tangible equity (ROTE) is a good measure of a bank’s overall profitability. ROTE guidance for 2024 across most of the major UK banks reflected the changing of the tide.

Those more exposed to performance dips in the short term are the banks like Lloyds and NatWest, who have more reliance on traditional lending than some of their globetrotting peers.

Interest rates are expected to fall over this year and next. But we’re not expecting a return to the close to zero-rate environment from just a few years back.

We see enough positive trends in other areas to make the sector worth a look.

Loan defaults stable

Loans are important assets for banks. But there’s always a chance some customer’s default on them. With living costs still feeling the effects of inflation and interest on debt adding pressure, there’s been concern that default levels could cause issues.

There are two main things we look at here.

The number of customers that have missed payments and are now in arrears, and the impairment charges taken in the income statement. The first does what it says on the tin, and impairments are charges taken in anticipation of future defaults – think of it as a safety net.

Looking at fourth-quarter impairments, they were better than markets expected across the board (this is a charge so lower is better). The negative figure for Lloyds was the reversal of a large impairment it had taken in the past which acted as a boost to profit.

For those customers who’ve already moved into arrears, the trend here has been fairly encouraging across both the UK and non-UK-focused banks.

NatWest and Lloyds both called out ongoing resilience across mortgages, cards and unsecured loans. Barclays which has decent exposure to UK and US credit cards pointed to the same strength from its UK customers. In the US defaults have been trending a little higher but are only a touch above pre-pandemic levels.

The Asian-focused banks, HSBC and Standard Chartered, are in a slightly different position. Commercial real estate exposure in China continued to be a cause for increased default risk. Across other areas like Hong Kong and the UK, trends have been more stable.

Real wage growth is back in the UK

Inflation has been a shifting beast, but more recent trends have allowed wage growth to outpace the general rise in prices. There are caveats to this, but broadly speaking if wages outpace inflation, then our real incomes go up.

With wages now outpacing inflation, there should be some watering down of the impact from mortgage borrowers refinancing onto higher rates.

And it’s come at a good time, as 2024 is expected to be the peak year for mortgage refinancing from the low levels seen around 2019. This has the potential to help keep new default levels down.

Deposit trends are improving

Customers shifting to longer-term accounts has been a thorn in the side of net interest margins, which measure the profitability of traditional borrowing/lending.

As rates increased last year, there was a shift away from low-interest current accounts over to higher-rate, longer-term saving products.

For the consumer, this means more interest on their cash. For banks, it’s a bit of a headache as they’ve had to battle to offer competitive rates and then pay out more in interest to keep deposits.

The good news for banks is that this trend seems to be slowing.

Looking at NatWest’s deposit trend, they had the biggest surprise back at third-quarter results, with a big jump in longer-term deposits. Term deposit increases slowed over the fourth quarter with a 1% increase compared to the 4% rise in the quarter before.

This slowing trend is something that’s been called out by peers too. If it continues, at least one of the headwinds will be slowing.

Valuations struggling to gain traction

In the chart above we’ve mapped profitability (return on equity, ROE) and valuation (price to book ratio) for a range of UK, US and EU banks.

In the top left corner HSBC, NatWest and Lloyds are some of the highest in terms of profitability, but at the low end on the valuation scale.

UK banks have been struggling to gain investor sentiment since the financial crisis imposed new regulations and Brexit put the UK outlook into question. However, we think there’s a case to be made that it’s gone a little too far and that brings with it opportunity.

Investing in an individual company isn’t right for everyone because if that company fails, you could lose your whole investment. If you cannot afford this, investing in a single company might not be right for you. You should make sure you understand the companies you’re investing in and their specific risks. You should also make sure any shares you own are part of a diversified portfolio.

The takeaway

There are no doubt challenges ahead. On the asset side, any surprise to inflation that keeps interest rates materially higher could push more borrowers into trouble.

The mortgage market is another headwind into 2024, with business weighted toward less profitable refinancing. But there has been positive recent news on the demand for new mortgages.

For the non-UK-focused banks, there’s a troubled Chinese economy and a broader slowdown in the investment banking world to contend with. But we think many of these challenges are well priced in.

In the case of Lloyds and NatWest, we see potential upside to current valuations. As ever though, there are no guarantees.

This article isn’t personal advice. If you’re not sure an investment is right for you, seek advice. Investments and any income from them will rise and fall in value, so you could get back less than you invest. Ratios also shouldn’t be looked at on their own. Past performance is not a guide to the future.

This article is original Hargreaves Lansdown content, published by Hargreaves Lansdown. It was correct as at the date of publication, and our views may have changed since then. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.