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Lloyds (LSE:LLOY) shares have pushed upwards from near their 52-week lows. The recent rally has been engendered by a slowing economy, falling inflation, and signals that central banks, including the US Federal Reserve, the Bank of England, and the European Central Bank, will lower rates.
While these triggers might not sound positive, they are. Higher interest rates are positive for lenders until they get too high. Essentially, the current 5.25% base rate in the UK increases the chances of a severe economic slump. In turn, this causes expected credit losses to rise as customers struggle with the repayments on their mortgages.
Interest rate conundrum
While interest rates were climbing in both the UK and globally, banks were undeniably in the spotlight, experiencing the direct consequences of monetary tightening.
This relationship is far from straightforward, but as the Bank of England raises rates, banks have the capacity to enhance their net interest margins — the gap between lending and borrowing rates — resulting in a positive impact on their interest income.
However, monetary tightening can also bring challenges.
The overarching concern is the potential for a surge in customer defaults, a scenario that could force banks to significantly increase their reserves for loan losses.
In this worst case scenario, these provisions could erode the positive impact of higher interest rates. For many banks, this is already happening.
However, Lloyds hasn’t reported a major uptick in impairment charges to date. This may be because Lloyds’s average customer has an annual income of £75,000, providing some degree of insulation against rising costs.
Worst case fading
Under Lloyds’s worst case scenario, the bank sees expected credit losses of £10.2bn. That’s more than double the predicted losses under the base case scenario.
However, we’re currently looking at a better than expected economic forecast. Traders have priced in 100 basis points of interest rate cuts in 2024, and the UK is set to avoid a recession.
The UK economy is now expected to experience slow growth in 2024, with GDP projected to expand by 0.4%. Meanwhile, the labour market is expected to remain tight, driving wage increases.
Of course, there is still a risk that the economy could deteriorate. We’re certainly not out of the woods yet.
Valuation
The thing is, Lloyds shares have been overlooked, in my opinion, because of the risks facing the UK economy, and by extension cyclical stocks like banks. In fact, Lloyds is more sensitive to this market than most of its peers as it doesn’t have a investment arm.
In turn, this is why Lloyds’s valuation metrics appear so attractive. The bank trades at 4.8 times TTM (trailing 12-month) earnings and has a price-to-earnings-to-growth (PEG) ratio of just 0.55.
The PEG ratio is an earnings metric adjusted for growth. A PEG ratio of one suggests fair value, and anything below is undervalued.
Thus, the bank’s PEG ratio infers that it could be undervalued by nearly 50%. This low PEG ratio is made possible by an expected earnings per share growth rate of 11.3%, reflecting improving economic conditions, and a strong fixed income hedging strategy.
So, could Lloyds shares double in 2024? It’s certainly possible. That’s why I’m topping up.
