Should You Invest in Banks Amid Higher Inflation?

British banks have been largely overlooked and unloved by investors in recent years, and perhaps for good reason.

Over the past decade, the FTSE All-Share has delivered a total return of 99.6%, while the UK banking sector has returned a paltry 17.5%.

Much of this dismal performance can be attributed to the rock-bottom interest rates and tight monetary policy since 2009.

But the UK remains heavily exposed to the financial sector – about 8% of the market – so some investors may reconsider their dislike of high-street lenders.

Will rising interest rates give their share prices a boost, or will the cost of living crisis dampen consumer confidence and their outlook for the year?

One of the biggest headwinds for the banking sector since 2009 has been rock-bottom interest rates.

Banks typically make money by taking deposits and lending them back to borrowers at higher interest rates and for longer periods.

You can also take long-term interest-free deposits and hedge them with interest rate swaps. These make up a bank’s net interest margin (NIM), but have been sharply reduced in this sustained low interest rate environment.

So, will the banks celebrate the Bank of England‘s fourth rate hike in six months?

Bank of England Governor Andrew Bailey has warned of a massive downturn” class=”blkBorder img-share” style=”max-width:100%” />

Bank of England Governor Andrew Bailey has warned of a massive downturn

“Higher interest rates are good news for banks as they allow them to earn a higher net interest margin,” said James Yardley, senior research analyst at FundCaliber.

‘For years, very low interest rates have made this incredibly difficult. Even a small change can have a big impact on such a highly aligned company.’

Ahead of the Monetary Policy Committee’s decision to raise interest rates, Lloyds said it expects a NIM of 270 basis points versus 250 this year and a return on tangible equity of more than 11 percent.

Adds Yardley: “The other thing that banks do for them is that they are very unloved and often trade at or near book value. That means you don’t have to see big positive changes to see a huge improvement in stock prices.’

But if interest rates continue to rise sharply, it could cool mortgage markets and lead to a rise in non-performing loans among consumers “who will also feel the effects of inflation and the sharp rise in the cost of living,” says AJ Bell Schimmel investment director Russ.

“Higher loan provisions could weigh even more heavily if the economy reels under the weight of rate hikes.”

Adds Yardley: ‘The downside of higher interest rates is that it could trigger problems in the housing market, as we saw in 2007 and 2008. With home prices so high relative to income these days, the market is vulnerable if demand for homes collapses.

“A collapse in property prices would be very bad news for banks. We’ve already seen banks start to position themselves for more mortgage defaults.’

While banks have welcomed the recent rate hike, they are unlikely to feel the same enthusiasm about the economic outlook.

The central bank issued a pessimistic forecast: it now expects inflation to peak at 10 percent at the end of this year after energy prices rose another 40 percent in the autumn.

This, coupled with the risk of a recession, does not bode well and even if interest rates rise, banks will suffer.

“As the UK economy appears to be slowing… and inflation has risen to a 30-year high of 7 per cent in the 12 months to March and double digits are expected for this summer – this is delivering a sour economic cocktail of rising inflation and slowing Growth and rising interest rates that even the banking sector finds difficult to accept,’ says Alice Haine, Personal Finance Analyst at Bestinvest.

“Add the aftermath of the war between Ukraine and Russia, such as: Such as staggeringly high energy prices, and it’s no wonder Brits are tightening their belts or being forced to borrow more to sustain their lifestyle – money they may not be able to pay back if the situation worsens.”

Figures from the Bank of England show that high street lenders are expecting an increase in the number of consumers struggling to pay off credit cards and other loans as the cost of living crisis deepens.

Lloyds boss Charlie Nunn recently said the bank is contacting customers “where”. [it] believes they may need support and will continue to help with financial health checks and other means of support.’

He added: “While we see continued recovery from the coronavirus pandemic, the outlook for the UK economy remains uncertain, particularly with regard to the persistence and impact of higher inflation.”

Add to that the fact that Lloyd’s has increased its pot to cover bad loans by £177m and it’s clear it’s worried about a spike in defaults.

Sophie Lund-Yates, senior equities analyst at Hargreaves Lansdown, adds: “Things are far from crisis levels, but a sharp economic downturn would hurt all banks.”

Shortage of money: Brits are tightening their belts or being forced to borrow more to meet their spending, which could mean banks have to spend more to cover defaults

The headwinds that have hit the sector since the financial crisis are likely to stay with it throughout the year and into next.

This could mean banks remain an unloved sector for investors, but Mold suggests it could mean they’re undervalued.

All five banks listed on the FTSE 100 trade at a discount to net asset value per share.

“Given the high CET1 ratios and relatively low leverage ratios, all five also meet regulatory capital requirements with ease, so they weathered the pandemic pretty well in that regard,” says Mold. “Especially as they spent much of 2021 writing back the bad loan provisions they hit in 2020 because their worst-case scenario didn’t materialize.”

If you think banking stocks are unfairly unloved and undervalued, there are many ways to get exposure to the sector.

Haine says: “Banks are well represented in the UK stock market, accounting for 8 per cent of the market, so a simple tracker like the Fidelity Index will give UK funds exposure.”

She also points this out TM Redwheel UK Equity Income, managed by Ian Lance and Nick Purves, targeting undervalued companies.

“Since December of last year, when the BoE hiked rates for the first time since the pandemic began, bank stock prices are now slightly ahead of the broader rate — although they sold off aggressively in mid- to late-February before recovering,” says Haine .

“How they will perform throughout 2022 will depend on how well they weather the economic challenges ahead.”

Yardley points to it Polar Capital Financials Trust and Jupiter financial opportunitieswhich have returned 54.9 percent and 27.41 percent over two years, respectively, but “have suffered along with the broader market in recent months.”

Mold adds, “The good news is that banks are cheap. The bad news is they might deserve it, especially when the economy slows, but a mildly inflationary recovery with gently rising interest rates and stock markets performing solidly would be a boon.

“Whether central banks can pull off such a dreamy soft landing remains to be seen.”