UK banks have underperformed continental European banks this year. The STOXX Europe 600 Banks index has posted a return of +16%, while UK bank shares have gone nowhere.
The reason is that the UK ($EWU) faces more severe economic challenges than either the US or the euro area. Inflation in the UK is running at 9%, compared to 3% and 6% in the US and euro area. At the same time, economic growth in the UK was only 0.2% year-on-year according to the latest data, while the US and the euro area grew at 1.8% and 1%.
Investors are afraid that the Bank of England will be forced to tip the UK economy into recession to get inflation back under control.
As a result, UK banks are hated and in the bargain bin. $BARC.L (Barclays) and $NWG.L (Natwest Group PLC) trade at 5x 2024E earnings, $LLOY.L (Lloyd’s Banking Group PLC) at 6x. These are far below the typical bank valuation multiple of 10x.
So how risky are the UK banks really?
Maybe not as risky as some fear, indicates a stress test released last week by the Bank of England. No bank failed the test, and Lloyds and NatWest passed with flying colours. Barclays also passed, although more narrowly, due to its higher-risk business model.
The Bank of England test simulated a scenario in which GDP falls 5% and house prices fall 31%. This is a far more severe scenario than the 10% drop current market forecasts for house prices imply, even if in the longer run, house prices could indeed fall more sharply because houses are currently severely overvalued in the UK.
Nevertheless, the most likely scenario given current global trends is that inflation will come down, the Bank of England can stop raising rates, and house prices will fall gradually over the next 5 years, giving UK banks the time to adjust.
We view the valuation level of 5x earnings as grossly exaggerating the risk of a financial crisis developing in the UK. That is why UK banks make up 20% of the portfolio.
If the UK economic situation stabilises, the three UK banks in the portfolio have more than 50% upside potential, should they return to a historically average valuation.