The banking system is critical to the future shape of any recovery in the real economy. We
have brought together analysis from our UK Economist, European Equity Strategists and UK
Banks analysts to better understand the dynamics of the UK economy through the next
cycle. The base case is more benign than we had anticipated (medium-term swap rates at
5%). By contrast, the risk case provides more concern (medium-term swap rates at a
still credible 7%, due to a higher risk premium rather than a growth recovery). Individually, we
attach different probabilities to the likelihood of this happening, but the implications if it does
are painful both for the economy and for equity market valuations.
Base case
Five-year swap rates remain broadly stable at around 5% and in line with forward market
expectations.
Bank loan rates are too low with run-rate new business ROE an unsatisfactory 8%. Reverse
engineering from a target 15-20% ROE under a new world regulatory rule book, run-rate
yields need to rise to 5.4-6.6% (+1.6-2.8pp). On an average or a marginal funding-price
basis, the cost of private-sector bank borrowing needs to rise from current levels. The
alternative is the UK is likely to remain credit constrained – particularly for those borrowers
with no access to capital-market funding alternatives.
The implications are clear – the cost of capital will polarise for borrowers with or without
direct capital markets access. European corporates (who are able to) will shift from bank to
capital-market funding, which supports the structural build-out of origination & distribution
capability beyond near-term yield curve/financial asset earnings recovery momentum.
Disposable income for the median-borrowed UK household rises sharply through 2009F on
the back of lower mortgage servicing costs. This trend reverses through both 2010F and
2011F due to higher taxes and a reversal in mortgage rates. But 2011F disposable income
would still be higher than 2008. And mortgage costs as a proportion of pre-tax income would
remain below the 31% threshold identified by the US authorities as a critical debt-servicing
level of 25-30%. Unemployment rising to over three million and a further 11% decline in
house prices combined with the trend reduction in disposable income will likely make 2010
and 2011 uncomfortable years for the UK economy, and highly leveraged borrowers will
suffer from a lack of refinancing alternatives. But overall mainstream asset quality should be
weak rather than disastrous.
The likely next leg of domestic UK banks sector outperformance will depend on their ability to
convince that new world ROE can credibly be sustained at the 15-20% level. This, historically
at least, would comfortably drive the UK banks sector valuation re-rating to 1.5-2x P/B (an
implied 10x normalised PE) from the current 0.8-1.2x; but will not be evident until next year at
the earliest. Barclays offers the best business mix for revenue growth; Lloyds should sustain
the best ROE as a lower cost/income ratio means higher pre-impairment profitability.
As for the broader equity market, modelling corporate earnings growth in line with this
subdued domestic economic outlook - arguably this is overly conservative given no
recognition of the exposure to higher-growth international markets that many large UK
companies offer - and adding a generous Equity Risk Premium still generates upside. Using
our house 10-year Gilt yield forecast alongside these assumptions suggests a ’fair value’ for
the FTSE100 of above 4,700 by year-end.
We suggest three distinct trading strategies that look appropriate to this muted domestic
growth backdrop: 1) long FTSE100 vs short FTSE250, which aims to take advantage of the
potential rise in the cost of capital for companies with material reliance on bank funding – far
less problematic for larger companies – and reflects a desire to buy ’market leadership’. In a
low-growth environment, the variation in earnings progress may prove less of a differentiator
than cost of capital, which should provide strategic advantage to dominant industry players;
2) short UK Consumer Discretionary. The two contrasting paths facing the UK economy
(base case vs stressed) have one point in common – the outlook for the UK consumer is
poor. After performing so strongly over the last 12 months, the UK Retail sector looks
expensive in relation to the lower trend growth likely to characterise the post 2009
landscape; 3) short domestic, long Emerging Market exposure – companies whose sales are
focused on the UK market are exposed to this prospect of lower trend growth, but there are
several names within the FTSE that generate a third or more of their revenues in high-growth
emerging markets. We construct stock baskets to exploit these geographic revenue
differences.
Stress scenario
Five-year swap rates rise to 7%. This could result from a disappointingly weak fiscal
adjustment, leading to a sovereign rating downgrade, weaker sterling and, so, a higher
required return by investors in light of a massive positive gilt supply that should become
evident as the QE safety blanket is removed.
Under this stress scenario the domestic UK banks should enjoy deposit spread expansion
but would still face the unpalatable choice of absorbing new business RoE dilution or risk
further aggravating the credit cycle by pushing loan rates above 7%. Our best guess is that
they would choose the former, so constraining new business RoE to 15%. This would likely
lead to increased corporate demand, as the logic for trend disintermediation reverses.
It would also take median UK household debt serviceability right to the threshold of
manageable levels. If the banks prioritised achieving a new business RoE of 20%, then the
required 8.5% loan yields would imply an extremely uncomfortable 19% reduction in
household disposable income on 2008 levels and 34% down on 2009. Put differently,
mortgage servicing costs would rise to 38% of household income, almost at the level
whereby new US legislation allows homeowners at risk to modify their debt terms. Under this
stress scenario, asset quality problems would move beyond the over-leveraged community
to become a major issue for mainstream borrowers.
From a valuation perspective, even sustaining 15% new business RoE would likely stop
domestic UK bank P/B valuations from rising much above 1x in the context of a 7% mediumterm
swap rate and the uncertainty of rising embedded losses in the existing loan book.