2018 was a difficult year for the UK stock market, with the FTSE All-Share falling by around 13%. However, particular pain was felt by shareholders of the UK’s major domestic banks (Lloyds, RBS and Barclays), which fell by almost twice as much, down 24% on average. Increased Brexit uncertainty was the major drag on share prices, in addition to the general market fears related to global growth and trade wars.
This performance was in stark contrast to relatively resilient earnings estimates during the year. Analysts made no real change to their 2019 earnings-per-share (EPS) forecasts for RBS and Barclays throughout 2018, and the consensus for Lloyds was actually 5% higher on 31 December than it had been on 1 January. Hence, the sector has de-rated quite dramatically in the last 12 months and now trades at on average forward price-to-earnings ratio of just 8x. To put this in context, this valuation level is around 20%-30% below long-run averages and about 35% below the FTSE All-Share.
Analysis undertaken by Citigroup (“UK Banks: Brexit & Credit Cycles”, UK Banks Big Picture, Winter 2018) concluded that a no-deal Brexit would drive EPS downgrades of between 15% and 25% for the domestic UK banks due to slower loan growth, lower-for-longer rates and a turn in the credit cycle. It could be argued, therefore, that the sub-sector is already pricing in the full earnings risk associated with a no-deal scenario.
In addition, UK banks are currently well capitalised. They all passed the recent stress test at the end of November, which included a disorderly Brexit scenario with no deal and no transition period in its analysis. The Financial Policy Committee (FPC) that carried out the test judged the banks to be “strong enough to continue to serve UK households and businesses even in a disorderly Brexit”. In the case of RBS, HSBC estimates that its surplus capital position was £6 billion (before special dividends and/or buybacks) at the end of 2018, which is around 20% of the bank’s market cap.
Clearly, stock prices will be driven mostly by Brexit-related news in the coming weeks, but there is an argument that the valuations of the UK domestic banks now fully price in the very worst case scenario.
Ian Butler is portfolio manager of the JPM UK Strategic Equity Income Fund within J.P. Morgan Asset Management's UK Equity team.
Source: Bloomberg as at 31 January 2019
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