For individual investors in the UK

Time to put your money in banks

Laura Foll, Portfolio Manager of Lowland Investment Company, considers whether concerns about the outlook for the banking sector are overly pessimistic and explains why the Trust has increased its exposure to banks over the last 12 months.

Laura Foll, CFA

Laura Foll, CFA

Portfolio Manager


19 Aug 2022
5 minute read

The International Monetary Fund says the outlook for the global economy has “darkened significantly” in recent months. Economists are pointing to inverted yield curves. Central bankers warn they expect to hike interest rates and are prioritising the defeat of inflation over short-term economic well being. Everything seems to suggest imminent global recession. So why have we increased our exposure to banks?

Historically, recessions have been bad news for banks – and their shareholders. This is because most recessions tend to follow periods when economies have overheated. A feature of the dog days of most economic upswings is that banks lend aggressively and even recklessly. The period just before the financial crisis is a great example of this.

When the cycle turns, unemployment shoots up, spending falls and businesses struggle. Then the defaults start to accrue – and bank directors look at their loan books and gulp.

This time it could be different. Governments have encouraged banks to lend throughout the past 12 years of Quantitative Easing (QE), while also constraining them. Banks have shored up their liquidity to meet tighter regulatory demands. They have made lenders meet more challenging stress-test requirements and have limited their lending to earnings ratios.

When Covid struck unexpectedly many of them made provision for significant defaults, expecting the economy to implode. It did not. The government stepped in, offering furlough handouts and loans to companies to keep the economy afloat. The risk associated with these loans is largely on the government’s balance sheet rather than with the banks.

Some suspected that unemployment would shoot up once furlough ended in autumn 2021, so it made sense to prepare for a weakened economy. This did not happen. In fact, in Q1 2022, UK unemployment dropped to 3.7% – its lowest rate since 1974.1

It means many banks are still sitting on the provisions they tucked away in anticipation of economic calamity. They can now fall back on this as a cushion. It is a fortuitous accident of history that they had not got round to unwinding all those provisions before the Ukraine crisis hit.

In the meantime, interest rates are now rising. Though this will eventually hurt some of their customers, it means that for the first time in over a decade banks might start to make a meaningful profit on the difference between the interest they earn on loans and that which they pay out to deposit holders.

Around 40 million consumers have easy-access savings accounts in Britain, according to the Financial Conduct Authority (FCA).2 Since December the Bank of England base rate has been raised five times – from 0.1% to 1.25% – but many major providers are yet to pass on any of this to savers.3 Some pay as little as 0.01%.4 They have not been so slow to pass on mortgage rate rises, though.

Concerns

While many banks seem to be in strong positions, there are still reasons to be wary. UK inflation hit 9.4% in June – a 40-year high – and some expect it to reach double digits later in the year.5 Household energy costs may rise an additional 40% in the autumn. The cost-of-living crisis is placing a strain on consumers, and we could see an increase in the number of people failing to make loan repayments.

Additionally, the banking sector is vulnerable to disruption. Challenger banks such as Starling and Monzo can offer more efficient, personal online banking experiences. Incumbents must invest in their service proposition and online offerings if they are to retain customers. This investment can often come at the expense of short-term earnings.

Then there is the faint possibility of dividend cuts. During COVID, the FCA forced banks to suspend dividend payments with very little warning – this is still in the very recent past, and it would be natural for shareholders to question whether it could happen again. However, it is likely banks would scale back share buybacks before cutting ordinary dividends. Bar further interference from the FCA, my expectation is that dividends can be held at or grow from current levels.

What we hold

We have increased our exposure to banks in the past 12 months and hold Lloyds, Barclays, NatWest and HSBC across our portfolios – in our view, it makes sense to be diversified. All four are forecasting a dividend yield of more than 4% over the next year. 6This is an above-market yield – and one we are very comfortable with.

Bank shares have not performed as you might have expected this year, given the rise in interest rates and anticipation of further increases. We have explained why we think concerns regarding bad debt may be overly pessimistic, but this theory could take time to be proved correct (or otherwise). In the meantime, we are being paid a healthy dividend in compensation for our patience.

Laura Foll is co-manager of the Lowland Investment Trust

These are the views of the author at the time of publication and may differ from the views of other individuals/teams at Janus Henderson Investors. Any securities, funds, sectors and indices mentioned within this article do not constitute or form part of any offer or solicitation to buy or sell them.

 

Past performance does not predict future returns. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.

 

The information in this article does not qualify as an investment recommendation.

 

Marketing Communication.

 

Glossary

 

 

 

Important information

Please read the following important information regarding funds related to this article.

Before investing in an investment trust referred to in this document, you should satisfy yourself as to its suitability and the risks involved, you may wish to consult a financial adviser. This is a marketing communication. Please refer to the AIFMD Disclosure document and Annual Report of the AIF before making any final investment decisions.
    Specific risks
  • If a trust's portfolio is concentrated towards a particular country or geographical region, the investment carries greater risk than a portfolio diversified across more countries.
  • Some of the investments in this portfolio are in smaller companies shares. They may be more difficult to buy and sell and their share price may fluctuate more than that of larger companies.
  • This trust is suitable to be used as one component in several in a diversified investment portfolio. Investors should consider carefully the proportion of their portfolio invested into this trust.
  • Active management techniques that have worked well in normal market conditions could prove ineffective or detrimental at other times.
  • The trust could lose money if a counterparty with which it trades becomes unwilling or unable to meet its obligations to the trust.
  • Shares can lose value rapidly, and typically involve higher risks than bonds or money market instruments. The value of your investment may fall as a result.
  • The return on your investment is directly related to the prevailing market price of the trust’s shares, which will trade at a varying discount (or premium) relative to the value of the underlying assets of the trust. As a result losses (or gains) may be higher or lower than those of the trust’s assets.
  • The trust may use gearing as part of its investment strategy. If the trust utilises its ability to gear, the profits and losses incured by the trust can be greater than those of a trust that does not use gearing.