Robert Stephens, CFA, discusses the prospects for FTSE 100 banks Lloyds and Barclays following strong share price performances.
Lloyds (LON:LLOY) and Barclays (LON:BARC) have bounced back extremely strongly from the 2020 stock market crash. The FTSE 100-listed banks are trading 70% and 115% higher, respectively, versus their lowest point in April 2020. In comparison, the index is currently 35% higher over a similar period.
The two banks continue to trade at cheap prices despite their recent gains. With an improving economic outlook and growing dividends potentially ahead, could they offer further FTSE 100 outperformance?
An economic transformation
The outlook for the UK economy continues to be highly uncertain. A full reopening was recently delayed, while the prospect of further containment measures over the coming winter remains a known unknown.
Despite this, the IMF forecasts that the UK economy will grow by over 5% in 2021 and in 2022. This suggests that the operating outlook for Lloyds and Barclays could dramatically improve over the coming months. A fast-growing economy may mean lower default rates, lower impairments and higher demand for credit. It could even strengthen calls for higher interest rates.
Of course, UK monetary policy is not due to substantially change until 2024 at the earliest. However, investor anticipation of a return to tighter monetary policy may act as a positive influence on share prices in the banking sector. Meanwhile, their profits could increase over the long term in an era where rising interest rates are used to counter higher inflation.
Solid performance
Both banks delivered encouraging results in the first quarter of the 2021 calendar year. Lloyds reduced operating costs by 2% because of its disciplined cost control. It also increased its common equity tier 1 (CET1) ratio by 0.54 percentage points. It now stands at 16.7%, which is significantly higher than the regulatory requirement of 11%, and suggests that it has a relatively sound financial position.
Meanwhile, Barclays delivered a record quarterly group profit before tax in the first quarter of 2021. The bank was aided by its international exposure, with Corporate and Investment Bank (CIB) income remaining robust despite uncertain operating conditions. Although its cost/income ratio increased to 61% from 52% in the comparable quarter from 2020, it continues to target a figure below 60% over the medium term.
Share price prospects
Valuations across the banking sector remain subdued even after strong share price growth. Indeed, Lloyds has a forward price-earnings ratio of 8, while Barclays trades on a forward rating of 7. Meanwhile, they trade 12% and 36% below their respective tangible net asset values. This indicates that their market valuations include wide margins of safety.
Dividend payments made by both banks are set to rise as the economy’s performance improves. Currently, dividend yields are expected to be 6.5% for Lloyds, and 5.3% for Barclays, in 2022. This could make them increasingly appealing in what may prove to be a prolonged era of low interest rates.
Clearly, such a situation is unlikely to be beneficial for the banking sector’s profitability in the short run. But with low valuations, improving financial prospects and a likely economic recovery that may spawn hawkish tones from the Bank of England, Lloyds and Barclays may offer further outperformance of the FTSE 100 over the long run.