Bank Watch: Challenger stocks set to lead in 2018

UK bank investors now have more choice, but that hasn’t necessarily brought better share price gains.

Banks barely beat FTSE

UK bank investors now have more choice, but that hasn’t necessarily brought better share price gains. The total return of a portfolio comprising 20 UK and Irish banks is just under 12% this year. That’s not much better than the FTSE. With the last few large lenders having released quarterly results in recent weeks, it’s clear why. Consumer and business credit has accelerated this year, and unemployment is at the lowest in four decades whilst the property market is resilient overall. But economic and political uncertainties (AKA Brexit) are capping corporate investment and growth.

These conditions will linger in 2018 and we think recovery stories at RBS, Lloyds and HSBC, are now almost complete. By extension, on a relative basis, we see the greatest potential upside further out to the ‘margins’ of the sector, i.e., amongst so-called challenger banks and elsewhere. We don’t exclude the likelihood that shares of the year’s Big 3 gainers can remain underpinned, though it’s a matter of degree.

Lloyds dividend eyed

Looking at Lloyds Banking Group, growth is already close to firing on all cylinders, on mortgages and credit cards, after the MBNA buy. Even if the group ends the suspense and announces a 50% dividend hike for the year, the shares would already have priced it. To be sure, Lloyd’s capital position would still be robust in such a scenario, up almost 1 percentage point. But the group’s all-in exposure to the UK as the biggest mortgage lender calls for greater certainty of continued growth than is possible ahead of Brexit. We expect investors to begin looking elsewhere.

Is RBS’s ‘good bank’ good enough?

For rival RBS, the biggest Big 4 riser this year, its lead is based on better than forecast operating profit in the third quarter and solid progress towards the goal of winding up its ‘bad bank’. At the same time, its ‘good bank’ is posting high double-digit return on equity. Nevertheless, RBS’s exposure to the UK is similar to that of its key domestic competitor, Lloyds. Loan to value on new RBS mortgages this year is tracking around 70%, up from around 50% in its existing portfolio, whilst group return on equity is in single digits. RBS’s leeway if the economy deteriorates and lifts impairments would be limited. For that reason, it’s hard to envisage another runaway year for its stock.

HSBC valuation looks full

HSBC, one of the clearest European bank recovery stories, has grown into a valuation that’s 5% above book value. That largely reflects strong deposit growth in Asia. As Europe’s largest provider of dollar-denominated accounts, with every 25 basis point Fed hike, HSBC expects to make $330m in net interest income. Still, whilst Q3 profits were solid, costs rose and earnings quality fell, tipping HSBC shares lower. The lack of confirmation that the group would continue to distribute its ballooning capital surplus via new buybacks has also weighed. HSBC shares are up almost 12% this year, though they’ve slowed having outperformed European banks by 50% over two years.

After a huge spate of asset sales over the last 18 months, HSBC’s shares hinge on at least two further potential large disposals. For one, HSBC Mexico has long been seen by the City as meeting the group’s criteria of ‘non-core’. Holding on to a 19% stake of China’s Bank of Communications also looks hard to justify. If both assets were sold, more buybacks could be announced with annual results in the spring. All in, we see HSBC’s stock as the likeliest among large lenders to tack on worthwhile gains next year.

Challengers seek consolidation

Challenger Banks will also remain in focus after Aldermore became the latest to be bought out last week. South Africa’s First Rand agreed to pay £1.1bn, a 22% premium, to take over the SME-focused lender. Aldermore shares are up 45% this year, the best performance by a UK bank stock in 2017. With Aldermore bought, and private equity having taken Shawbrook private in July, pressure on challengers to give up control is rising. Weak sterling, lingering soft rates and higher capital requirements are weighing on the smallest banks hardest, keeping consolidation on the minds of many challenger CEOs. CYBG’s, for instance, was keen to buy RBS’s Williams & Glynn unit before RBS pulled the sale. Virgin Money’s CEO said in May she had “looked at everything in the market”. OneSavings’ boss said in the spring he was “always chatting”.

Conclusion

We therefore expect speculation to drive most challenger shares higher than stocks of established lenders in 2018. However, with the retail segment likely the most attractive to potential buyers, and with the pound still challenged, further overseas interest is also predicted. This keeps Metro, OneSavings and possibly, Virgin Money in the frame.

UK/Ireland bank stock gains and losses (3 months)

Bank Stock

High Date

Low Date

Percent Change

Aldermore Group PLC

06-Nov-17

07-Sep-17

43.54%

Alliance Trust PLC

03-Nov-17

15-Sep-17

3.08%

Allied Irish Banks PLC

09-Oct-17

20-Sep-17

5.26%

Arbuthnot Banking Group PLC

14-Aug-17

11-Oct-17

-5.99%

Bank of Ireland Group plc

16-Aug-17

25-Oct-17

-8.32%

Barclays PLC

16-Aug-17

13-Nov-17

-10.94%

Close Brothers Group PLC

01-Sep-17

13-Nov-17

-12.28%

CYBG PLC

13-Nov-17

29-Aug-17

12.21%

HSBC Holdings PLC

10-Oct-17

15-Sep-17

-0.39%

Lloyds Banking Group PLC

26-Oct-17

06-Sep-17

2.31%

Metro Bank PLC

06-Nov-17

26-Sep-17

2.63%

OneSavings Bank PLC

24-Oct-17

04-Oct-17

-0.52%

Paragon Banking Group PLC

01-Nov-17

07-Sep-17

8.59%

PCF Group PLC

26-Oct-17

20-Sep-17

14.43%

Rathbone Brothers PLC

25-Aug-17

13-Nov-17

-9.92%

Royal Bank of Scotland Group PLC

27-Oct-17

07-Sep-17

6.18%

Standard Chartered PLC

24-Oct-17

01-Nov-17

-3.65%

Virgin Money Holdings (UK) PLC

18-Oct-17

22-Aug-17

0.88%

Source: Thomson Reuters and City Index

Join our live webinars for the latest analysis and trading ideas. Register now

GAIN Capital UK Limited (trading as “City Index”) is an execution-only service provider. This material, whether or not it states any opinions, is for general information purposes only and it does not take into account your personal circumstances or objectives. This material has been prepared using the thoughts and opinions of the author and these may change. However, City Index does not plan to provide further updates to any material once published and it is not under any obligation to keep this material up to date. This material is short term in nature and may only relate to facts and circumstances existing at a specific time or day. Nothing in this material is (or should be considered to be) financial, investment, legal, tax or other advice and no reliance should be placed on it.

No opinion given in this material constitutes a recommendation by City Index or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person. The material has not been prepared in accordance with legal requirements designed to promote the independence of investment research. Although City Index is not specifically prevented from dealing before providing this material, City Index does not seek to take advantage of the material prior to its dissemination. This material is not intended for distribution to, or use by, any person in any country or jurisdiction where such distribution or use would be contrary to local law or regulation.

For further details see our full non-independent research disclaimer and quarterly summary.