UK banks: A look ahead to earnings

The backdrop

UK banks have had a rough quarter. The FTSE350 banking sector has fallen over 8% in Q3, vastly underperforming the FTSE100, which fell 3.7% across the same June to September period. September was a particularly weak month, with the bank stocks dropping 8% as investors assess the deteriorating economic outlook and look ahead to Q3 results. However, these results may not be as bad as feared, thanks to higher interest rates and a recession still not showing up in GDP data.

Interest rates

The BoE has raised interest rates consistently over Q3, and big banks have also steadily built up their reserves at the central bank.

Rising interest rates are often good news for banking stocks, as they mean a rise in net interest income, the difference generated between the amount that a bank earns from lending and the amount that it pays out to depositors. Furthermore, banks have failed to pass on the gains of higher base rates to savers. Barclays still only pays 0.25% on its easy-access account.

After the Chancellor’s expansive mini-budget, which sent gilts and the pound tanking as investors lost confidence in the UK, the BoE will likely have to hike rates more aggressively to counter the expansionary and inflationary measures. This could result in more profits for banks even after mortgage products are pulled.

Mortgages pulled

When interest rates rise, so do mortgage rates. A strong rise in interest rates means that mortgage rates are also expected to rise strongly. Amid all the uncertainty over where interest rates could be going many lenders pulled mortgage deals in the fallout from the min-budget.

This means that a core revenue stream for the likes of Lloyds and NatWest sources could start to dry up. However, this is more likely to impact Q4 than the Q3 numbers. The fact that the housing market is also expected to crash adds to the sector’s headwinds. However, this will also be in coming quarters. So far, the housing market is still seeing price rises of around 10 per year.

Recession

The UK’s economy is heading for a recession. While UK Q2 GDP data showed that a contraction was narrowly avoided, it would appear almost impossible for the UK to avoid falling into recession, marked by two consecutive quarters of negative growth, by the end of the year.

In times of recession, bad loans can rise quickly. We can expect the amount that banks need to put aside for bad loan reserves to increase over the coming quarters, which will hit earnings. Households across the UK could struggle to pay their mortgages, and a reduction in the number of loans as few want to or can afford to borrow at high rates means that any benefit from higher NII is quickly overshadowed. However, we are not there yet.

Trading

Those banks, such as Barclays, with larger trading arms, could benefit from the high levels of volatility that we’ve seen in the markets over the past few months. That said investment banking operations such as IPO’s and M&A activity has stalled this year.

Still, the financial markets work on a forward-looking basis, and there are clearly concerns that troubled times are coming. Still better than expected results in Q3 could give the banks a boost, even if it’s temporary.

It is worth watching US bank’s earnings closely, which kick off on Friday. Whilst the economic outlook for the YK is worse than the US, US banks’ performance will give some clues as to what to expect from UK banks.