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Someone in The Market Has Got UK Banks Totally Wrong

Kwasi Kwarteng, UK business secretary, departs from the Conservative Party leadership contest announcement in London, UK, on Monday, Sept. 5, 2022. Liz Truss won the bitter race to succeed Boris Johnson as UK prime minister, and will take power with the country facing brutal economic headwinds that threaten to plunge millions of Britons into poverty this winter.
Kwasi Kwarteng, UK business secretary, departs from the Conservative Party leadership contest announcement in London, UK, on Monday, Sept. 5, 2022. Liz Truss won the bitter race to succeed Boris Johnson as UK prime minister, and will take power with the country facing brutal economic headwinds that threaten to plunge millions of Britons into poverty this winter. (Bloomberg)

No one is quite sure whether Chancellor of the Exchequer Kwasi Kwarteng, is friend or foe for UK banks. What is obvious right now: Somebody is wrong.

Investors haven’t much fancied shares of the biggest UK lenders all year and they sold them with gusto in the market meltdown triggered by the country’s biggest tax-cutting package in five decades, which announced on Friday.

But brokers have steadily lifted earnings forecasts for Barclays Plc, HSBC Holdings Plc, Lloyds Banking Group Plc, NatWest Group Plc and many smaller rivals all through the year. The argument in support of optimism right now is simple: Higher interest rates boost revenue and energy subsidies protect borrowers, the economy and therefore banks. Joseph Dickerson at Jefferies estimates the energy-price cap saves UK banks 2% of domestic profits next year by reducing defaults on consumer loans. 

After Friday’s budget, Kwarteng told finance chiefs his policies would generate growth and promised them a wave of deregulation at a meeting on Tuesday.

Meanwhile, many British consumers, like their US counterparts, are cushioned by more than £200 billion ($215 billion) in excess savings built up during the Covid-19 pandemic, according to data from the Office for National Statistics. Household debt-to-income ratios have also barely changed in eight years and remain far below the 2008 peak, according to the Bank of England. Lending to households looks low risk and increasingly profitable.

So what’s with the stock price declines? There is undoubtedly a renewed rise in risk premiums attached to the UK, which simply means investors demand a higher return to hold British assets due to the economic and political uncertainty the country keeps managing to generate. Shares of UK-focused banks like Lloyds have suffered a Brexit discount since the 2016 vote to leave the European Union. Lloyds and its equally UK-centric rival NatWest are down 9% and 15%, respectively, since the start of last week, much worse than the more international Barclays or HSBC. All apart from HSBC are down for the year, but earnings-per-share forecasts for 2022 at the four banks have risen by between 13% and nearly 40% over the course of the year.

Some of this may be just passing fear sparked by Kwarteng’s seemingly cavalier approach to Britain’s long-term financial health: Big spending commitments along with tax cuts and few details of how these might balance out. But the consequent sharp jump in UK government borrowing costs and sickly reaction of the pound illustrate the potential for real economic risks: higher inflation through import prices, increased interest rates curbing demand and potentially rising unemployment as a result. Joblessness is particularly bad news for lenders.

Investors also might just be trying to reassess what cost of equity they should apply to banks, according to Andrew Coombs, analyst at Citigroup Inc. This is the minimum level of return an investor should expect and it is typically estimated at about 10% for banks. Coombs currently applies a cost of equity of 11-12% for UK banks, in line with other European banks but higher than the broader UK stock market.

Apart from HSBC, the big UK banks are trading at a much higher implied cost of equity, based on a simple model using return-on-equity forecasts and current valuations in terms of price to book value. Lloyds and NatWest both have an implied cost of equity of about 15%, while Barclays is at 18%, although that is likely down to its investment bank, a riskier and more volatile business.

The alternative, of course, is that the earnings and returns forecasts are too high: It is the brokers being too optimistic, not investors being pessimistic. 

There is plenty that could hurt banks, especially hits to disposable incomes. The energy-price cap will protect consumers to some degree but still leave them paying bills roughly twice the size of last year’s. Rising interest rates will bite on mortgage costs too: The vast majority of borrowers have loans where rates are fixed for up to five years, but about one-sixth of those are due to reprice over the next year at interest rates that could be two to three times higher. Also, the share of households with debt-service costs worth more than 40% of income – which indicates a higher risk of repayment problems in troubled times – had already been rising from a low base, according to the Bank of England.

The government wanted to stimulate spending and growth with its income-tax cuts, but it handed half the benefits to the richest 5% of people and two-thirds to the top 20%. Britain’s wealthy very likely sit on the greater share of the £200 billion-plus excess savings put away during the pandemic. In other words, the wealthy are already not spending the cash piles they have, so giving them more money seems pretty unlikely to boost the economy.

High rates, weak growth and inflation would make a grim economic outlook. Add in government spending cuts to balance its budget or rising unemployment or both and the outlook for credit losses at British lenders will get much worse.

Long-term decisions are tough in the midst of noise like the market mayhem of recent days: Some mortgage lenders stopped offering new loans while they wait to see where their own funding rates will settle. But I would guess that domestic earnings forecasts for UK banks are going to be cut in the months ahead. Investors have it more right than the analysts.

More From Bloomberg Opinion:

• Can Kwasi Kwarteng Claw Back Credibility?: Raphael and Hanson

• Brexiteers Want a Piece of the Bank of England: Paul J. Davies

• The Gap Keeps Widening Between the US and Europe: Lionel Laurent

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Paul J. Davies is a Bloomberg Opinion columnist covering banking and finance. Previously, he was a reporter for the Wall Street Journal and the Financial Times.

More stories like this are available on bloomberg.com/opinion

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