Why the banks matter for the markets in 2017

The health of UK banks is important to any investor with exposure to the UK equity market. The big five quoted names – Barclays, HSBC, Lloyds, Royal Bank of Scotland and Standard Chartered – represent around 15% of aggregate FTSE 100 pre-tax profit and dividend payments, according to analysts’ consensus forecasts for 2017, with HSBC and Lloyds both in the list of 10 largest cash distributors.

Banks are seen as a key contributor to FTSE 100 earnings and dividends in 2017

		Forecast pre-tax profit contribution			Forecast dividend contribution
1	Banks	15.8%	1	Oil & Gas Producers	22.9%
2	Oil & Gas Producers	14.6%	2	Banks	15.5%
3	Beverages & Tobacco	10.3%	3	Beverages & Tobacco	11.4%
4	Pharmaceuticals / Healthcare	8.4%	4	Pharmaceuticals / Healthcare	9.7%
5	Insurers	7.2%	5	Insurers	6.8%
6	Mining	7.0%	6	Telecoms	6.6%
7	Travel & Leisure	4.9%	7	Utilities	5.2%
8	Food Producers	4.5%	8	Travel & Leisure	3.8%
9	Telecoms	4.1%	9	Media	3.6%
10	Media	4.0%	10	Mining	3.3%
11	Utilities	3.7%	11	Industrials	2.6%
12	Support services	3.3%	12	Food Producers	2.3%
13	Industrials	3.1%	13	Support services	2.3%
14	Construction & Materials	2.1%	14	Construction & Materials	2.1%
15	Personal / Household	1.9%	15	Personal / Household	1.8%
16	General Retailers	1.5%	16	Real Estate	1.3%
17	Other financials	1.4%	17	Other financials	1.3%
18	Food Retailers	1.0%	18	General Retailers	1.3%
19	Real Estate	0.7%	19	Food Retailers	0.8%
20	Technology	0.5%	20	Technology	0.2%

Source: Digital Look, analysts’ consensus forecasts

The good news is that only Royal Bank of Scotland fails the Bank of England’s third annual stress test and the others all pass with varying degrees of comfort.

However, one of the scenarios outlined does assume that all of the banks could either cut or fail to reinitiate dividend payments to shareholders, in the event they needed to build up an additional layer of safety during a period of market and economic stress.

This highlights the great debate over the Banks sector. The grouping has rallied strongly in the second half of 2016, boosted by hopes for pro-growth policies from new leaders and administrations in both the UK and USA, the prospect of a steepening yield curve and a view among contrarians that the stocks are cheap and the bad news already discounted.

Value players have been in the vanguard here, while fund managers with a preference for quality, more defensive names have largely shunned the sector. At around 13% of the FTSE 100’s market cap, this is a key area to get right in 2017 and it will be important for investors to divine a money manager’s view on Banks before they commit capital to a fund or investment trust – tracker funds will provide that 13% weighting as a matter of course, so anyone taking the passive option at least knows what exposure they are getting on this front.

Stressed out

While RBS is the sole bank to fail the new stringent stressed scenarios outlined by the Bank of England, only HSBC and Lloyds pass the minimum capital requirements and the tougher balance sheet tests targeted by the Old Lady of Threadneedle Street without the need for additional capital raising, dividend cuts or the conversion of so-called AT1 bonds into shares.

These tests demand that the banks meet a minimum level of Core Equity Tier 1 (CET1) capital as a percentage of their overall assets, so they withstand losses during a range of potential negative outcomes and not require further financial assistance.

The aggregate hurdle rate for the big five quoted banks, plus Nationwide and Santander UK is 6.5% with the additional Systemic Reference Point at 7.3%.

The worst-case scenario used to challenge the banks’ financial health includes

• a deep recession in the UK, featuring a 4.3% peak-to-trough drop in GDP
  
• a 1.9% drop in global economic output
  
• a 4.5 percentage point increase in UK unemployment
  
• a 31% drop in UK house prices
  
• a 42% drop in UK commercial property values
  
• a property slump in Hong Kong and China
  
• a drop in oil to $20 a barrel

Under these exacting circumstances Barclays and Standard Chartered both miss their targeted capital levels although the Bank of England remains confident that each is already capable of, and working, on raising the additional liquidity.

HSBC and Lloyds did best among the quoted banks in the stress tests, RBS the worst

	Q3 2016	Hurdle rate	Systemic reference point		Stress-tested ratio minimum	After all actions
Barclays	11.6%	6.8%	7.8%		5.9%	8.3%
HSBC	13.9%	6.1%	7.3%		7.6%	9.1%
Lloyds	13.5%	7.0%	n/a		9.7%	10.3%
Nationwide	23.3%	8.1%	n/a		15.0%	15.6%
RBS	15.0%	6.6%	7.1%		5.5%	6.7%
Santander UK	11.1%	7.3%	n/a		9.9%	9.9%
Stan Chart	13.0%	6.1%	6.6%		5.5%	7.2%
Aggregate	13.5%	6.5%	7.3%		7.3%	8.8%

Source: Bank of England

One tactic each could use to build up an additional buffer is to further cut their dividends, following the reduction pushed through over the last two years. As the report puts it: “During a stress, with a significant fall in bank profits, investors should expect a material cut in dividends.”

The Bank of England’s tests assume, in a most extreme case, that RBS holds its dividend at zero and Barclays, Lloyds and Standard Chartered cut their payments to nil. The scenario also assumes HSBC cuts its shareholder pay-out by around three-quarters, cutting its prospective dividend yield from 6.3% to around 1.7%.

While this seems unlikely – and certainly runs counter to the dividend policy outlined by HSBC boss Stuart Gulliver – it does outline the importance of the banks to income-seeking investors.

HSBC is the leading name here, with a forecast 6.3% dividend yield but earnings cover is below the 2.0 times threshold which gives comfort. Cover is better at the lower-yielding names.

Banks offer either fat yields and thin earnings cover or vice-versa

Source: Digital Look, consensus analysts’ forecasts

Wider implications

The nitty-gritty of individual banks’ financial statements and balance sheets is unlikely to be on the radar of all investors, many of whom will not have the time for such niceties (and will employ a fund manager to do this work for them).

But the wider importance of banks for the UK market cannot be ignored.

In the event of a market and economic downturn – and especially the scenario outlined by the Bank of England - the damage done to earnings as well as dividends would doubtless also be considerable. This could hold back progress at the wider market level, given the importance of the Banks sector’s contribution to forecast growth in profits and dividends in 2017.

Banks are seen as a key contributor to FTSE 100 earnings and dividend growth in 2017

	Forecast pre-tax profit growth contribution			Forecast dividend growth contribution
Banks	15.2%		Banks	17.8%
Insurers	4.5%		Insurers	10.0%
Other financials	-0.1%		Other financials	3.0%
Support services	1.0%		Support services	3.8%
Mining	23.9%		Mining	10.8%
Food Producers	1.6%		Food Producers	3.1%
Food Retailers	0.6%		Food Retailers	4.9%
General Retailers	0.0%		General Retailers	-0.2%
Beverages & Tobacco	2.5%		Beverages & Tobacco	16.6%
Technology	0.2%		Technology	0.6%
Telecoms	2.9%		Telecoms	3.7%
Travel & Leisure	1.6%		Travel & Leisure	6.8%
Real Estate	0.1%		Real Estate	1.2%
Oil & Gas Producers	35.7%		Oil & Gas Producers	-0.1%
Pharmaceuticals / Healthcare	5.0%		Pharmaceuticals / Healthcare	-0.5%
Media	2.5%		Media	4.9%
Utilities	0.5%		Utilities	2.6%
Industrials	1.4%		Industrials	2.2%
Construction & Materials	0.2%		Construction & Materials	5.5%
Personal / Household	0.9%		Personal / Household	3.2%

Source: Digital Look, analysts’ consensus forecasts

As can be seen here, a healthy banks index is usually important for a good performance from the UK equity market overall.

Strongly performing banks used to be a good sign for the wider market

Source: Thomson Reuters Datastream

This makes sense, given the importance of banks to earnings and dividends, but also to the wider economy, given their role as a key provider of the credit and liquidity that lubricate the UK engine.

In the doldrums

The poor performance of the banks since the Great Financial Crisis may help to explain why the FTSE 100 has made such a meal of decisively breaking out beyond 7,000 mark, as they have acted like deadweight.

With the exception of 2012, the sector ranked in the bottom 10 of the 39 groupings which make up the FTSE All-Share every year between 2010 and 2015, even as the wider market has recovered from its lows.

Bank stocks have generally done poorly since 2009

Source: Thomson Reuters Datastream

This year began badly as well but the sector has rallied in the second half of this year, climbing the sector rankings, having been dead last for most of the first six months.

The Banks sector has rallied in the second half of 2016

Source: Thomson Reuters Datastream

Fresh rally

This rally has its origins in the turgid run between 2010 and 2015 as the unloved banks found themselves dogged by competition from challenger banks, ever-more-stringent regulation and a string of fines for misconduct, not to mention a soft economy where debt levels remained uncomfortably high.

All of this at least contrived to leave the banks looking cheap as the market concluded the sector’s earnings power would be crimped for some considerable time to come.

Banks’ earnings (and dividends) can be volatile so analysts can use book value, or net asset value – the underlying worth of their assets once all liabilities are settled – as a potentially more reliable metric.

Anything less than one times NAV and a bank could be potentially be trading at a discount to its assets, although the trick here is to make sure you have faith in the valuation of the assets presented by the bank’s balance sheet. Again, the details may to be of import to all advisers and clients but it is interesting to note that all of the UK’s Big Five trade at one times NAV or less, with the exception of Lloyds, which trades at a tiny premium.

The Banks sector could be cheap on a net asset value basis

Source: Thomson Reuters Datastream

This could be a start – assuming again the balance sheet valuations are sufficiently conservative in the first place. But lowly valuations still need a catalyst to trigger them and the second-half rally suggests one may have arrived.

Hopes for pro-growth, pro-inflation policies in the form of corporate tax cuts and infrastructure spending from US President-Elect Donald Trump and UK Prime Minister Theresa May have sent bond yields moving higher, especially for longer-dated paper.

That means the yield curve has steepened, as the gap between the yield on 10-year and 2-year Government gilts has widened. This has been seen as good news for banks’ profits as they normally borrow at the short end of the curve (where yields are lower) and lend at the long end (where yields are higher), pocketing the difference as their profit margin.

The cause and effect can be seen clearly this year.

In late 2016 banks have responded to a steepening of the yield curve...

Source: Thomson Reuters Datastream

Fund exposure

This creates an interesting situation when it comes to fund selection. Known contrarians such as Richard Buxton of Old Mutual UK Alpha, Alistair Mundy of Investec UK Special Situations and Temple Bar Investment Trust are espousing the value case for unloved banks and have their portfolios positioned accordingly. Buxton has HSBC and Lloyds in his top 10 holdings list, whilst Mundy has those and Barclays and RBS for good measure at Investec UK Special Situations, while he owns the first three in the top 10 at Temple Bar.

Yet they are far from in the majority and banks have represented a huge pain trade for many fund managers in the second half of 2016, as they have been underweight and caught off guard by the dash from quality growth and defensive stocks to cyclicals, financials and turnaround plays.

One question investors therefore need to address for 2017, if they are looking at UK exposure, is how a fund manager is positioned with regard to the banks, as getting them right could go a long way to shaping whether they outperform or not.

Any fund manager wary of the May-Trump reflation trade may fight shy of them, in the view inflation and growth hopes are overdone, the bond sell-off overcooked and the yield curve is already too steep. Bulls of the sector may buy into the opposite view, or simply believe the valuations are too tempting to ignore.

To help investors on their way, the final two tables show the top 10 performing fund and investment trusts over the last five years and illustrate which – if any – of the big five banks they have in their top 10 holdings.

The weighting for financial stocks overall is also shown, as life insurers are also potential beneficiaries of the steepening yield curve theme.

Top 10 performing UK equity funds’ bank exposure

Fund	Financials weighting	Barclays	HSBC	Lloyds	RBS	Standard Chartered
Investec UK Alpha I (Acc) Net	10.0%
Ardevora UK Equity B	6.0%
Majedie UK Focus X (Inc)	29.2%	5th	6th		7th
Lazard UK Omega Retail C (Acc)	20.8%	9th
Invesco UK Equity C	29.5%	3rd	9th		8th
SEI UK Equity GBP Wealth A (Inc)	19.0%		2nd
Threadneedle UK Extended Alpha Instl. Net GBP (Acc)	14.7%
Jupiter UK Growth I (Acc)	21.8%	3rd		2nd
RWC UK Focus B (GBP)	24.0%
Threadneedle UK Growth & Income ZNI	9.6%

Source: Morningstar, Company factsheets

Top 10 performing UK equity investment trusts’ bank exposure

Fund	Financials weighting	Barclays	HSBC	Lloyds	RBS	Std Chartered
JP Morgan Mid Cap	18.1%
Henderson Opportunities	8.2%		4th
Crystal Amber	3.5%
Invesco Perpetual Select UK Equity	n/a
Mercantile	20.0%
Schroder UK Mid Cap	12.0%
Threadneedle UK Select Trust	14.2%
Keystone	17.3%
Schroder UK Growth	18.1%			5th
Jupiter UK Growth	24.3%	1st		2nd

Source: Morningstar, Company factsheets

Russ Mould, AJ Bell Investment Director