Lloyds Banking Group (NYSE: NYSE:LYG) will face new headwinds from weaker economic growth and inflationary pressures following the Russian invasion of Ukraine. The bank delivered an impressive turnaround in profits last year, but the earnings momentum could stall due to a rise in credit costs and a lower interest rate outlook over the medium term.
Buoyed by a faster than expected recovery in the UK economy, Lloyds’ full-year profits more than quadrupled to £5.9 billion (~$7.7 billion). Its return on tangible equity (RoTE), a key measure of profitability, rose to 13.8% - its highest level for more than a decade.
The release of £1.7 billion (~$2.2 billion) which had been previously set aside as loan loss provisions was by far the important factor for the rebound in profitability. And this was only made possible by the improvement in the UK's macroeconomic outlook over the past year, which reduced the likelihood that borrowers would default on their loans. The underlying impairment credit for the year was £1.2 billion (~$1.6 billion), compared to a £4.2 billion charge recorded in 2020 (~$5.5 billion).
Nevertheless, higher-than-expected remediation costs for compliance failings caused Lloyds to miss analysts expectations on earnings. The Group reported a further £1.3 billion (~$1.7 billion) charge with respect to historic fraud at its HBOS Reading branch, past home insurance renewals and other legacy issues.
Following a strong set of results, new management guidance for its medium-term profitability was issued - RoTE is now expected to be more than 10% from 2024 onwards, rising to above 12% by 2026.
In addition, it expects to deliver the following:
Generate additional revenues from strategic initiatives of around £0.7 billion (~0.9 billion) by 2024 and more than double that to around £1.5 billion (~$2.0 billion) by 2026
Business-as-usual costs flat in 2024 versus 2021, with a cost-to-income ratio of less than 50% by 2026
Asset quality ratio to be less than 30 basis points over 2022 to 2024
Capital generation of around 150 basis points per annum over 2022 to 2024, improving to 175 to 200 basis points by 2026.
The bank also gave guidance for the current financial year. For 2022, the bank expects:
Banking net interest margin to be above 260 basis points
Operating costs of around £8.8 billion (~$11.5 billion) on the new basis, with the increase from the 2021 equivalent of £8.3 billion (~$10.9 billion)
Asset quality ratio to be around 20 basis points
RoTE of around 10%
Risk-weighted assets at the end of 2022 to be around £210 billion (~$275 billion)
The UK lender may find it more difficult to achieve these targets following the Russian invasion of Ukraine. Spiraling commodity prices, amid supply concerns for key industrial and agricultural commodities, has clouded the recovery prospects of the UK economy.
The recent drop in long-dated sterling-denominated bond yields and a flattening of the yield curve suggests the likelihood of a recession is now substantially higher. Even if a recession does not materialize, Lloyds would be impacted by a slower pace of central bank rate hikes and longer for longer interest rates.
This is because, as real household incomes in the UK will be squeezed by the impending supply shock, loan demand and affordability would be impacted. Analysts expect household energy bills could soar to more than £3,000 (~$3,900) a year from October this year, up from around £1,200 (~$1,600) currently. Additionally, inflationary pressures from food prices, freight costs and other industrial commodities would affect almost every other category of consumer spending.
At the same time, planned tax increases are also set to bite - with the 1.25 percentage point increase to National Insurance contributions, the UK’s social security scheme, due to take effect from April 6, 2022.
These pressures will likely take its toll on expectations for economic growth, unemployment rates and house price growth; and in turn, this would impact loan demand, fee revenue growth and credit quality.
As things stand, it is still possible for Lloyds to hit its medium-term RoTE targets. The rising interest rate environment will still be a very meaningful tailwind, even as expectations have recently been pared back.
The structure of the balance sheet and low pass-through of rate hikes to depositors makes Lloyds particularly sensitive to interest rate changes. An upwards parallel shift of 50 basis points in the interest rate curve is expected to add around £375 million (~$490 million) in net interest income in the first full year. The cumulative benefit would rise to around £800 million (~$1.0 billion) after three years.
Estimated cumulative impact to net interest income from parallel shifts in the interest rate curve (£ millions)
|Year 1||Year 2||Year 3|
Source: Lloyds Banking Group 2021 Results Presentation
Management’s interest rate outlook appears to be conservative. Its base economic case puts the Bank of England base rate at 1.0% by the end of the year, suggesting a 75 basis point increase in 2022. This would be equivalent to three quarter-percentage point rate hikes (two more following the February quarter-point increase) - lower than what many analysts predict and what the futures markets are pricing in for.
Currently, a total of four quarter-point rate rises are priced in for 2022, down from five to six in February. This should be enough to offset a modest increase in credit costs and slightly slower revenue growth. Of course, this could all change if the risk of a recession continues to increase.
It would be more difficult to achieve its 2022 year guidance though, as the benefit of higher interest rates takes some time to fully feed into its bottom line. It is therefore more onerous that the bank achieves its asset quality ratio target of around 20 basis points in the year, in order to meet its shorter-term RoTE target of 10%. And this would be really challenging amid a deterioration in the macroeconomic environment.
Meeting investors’ expectations would then be even more difficult. Right now, the consensus forecast for earnings in 2022 and 2023 imply the bank is expected to generate a RoTE in excess of 11% in each of the next two years. Achieving this higher profitability target level would appear to be dependent on the cost of risk remaining historically very low, perhaps, even requiring further provision releases.
Further downward revisions in earnings estimates are likely still to come.
To help deliver growth in the medium term is also Lloyds’ ambitious plan to generate new sources of revenue. The strategy involves expanding its mass affluent wealth management offering, broadening its finance proposition to attract bigger corporate clients and scaling up Citra Living, its private home rental business.
Management expects the proposed strategic initiatives to add nearly 10% to its annual revenues by 2026. But unlike the benefit of higher interest rates, these additionally revenues won’t translate one-to-one to its bottom line, due to higher operating expenses and investment costs needed to grow these new business lines.
Still, with limited growth prospects in the core retail lending business, the bank is keen to put its excess capital generation to expansion, rather than simply return more capital to shareholders. New revenue sources would also increase diversification and grow its share of revenues from fees and commissions, reducing its sensitivity to interest rates.
The bank certainly has the ecosystem and customer relationships that it can leverage on to broaden its offering, which could give it a competitive advantage over existing rivals.
That said, execution risks are elevated. The group has long struggled to find new sources of growth. That is why, after failed forays into investment banking and international expansion before the financial crisis of 2007/8, the bank retreated to focus on its core retail banking operations in the UK, an area where it has been a clear market leader.
Lloyds’ recent joint venture with Schroders in the financial planning and wealth management market still has a lot to prove. It attracted just £0.3 billion (~$0.4 billion) in net new business in 2021 - just roughly equivalent to its net outflows in the previous year.
The earnings outlook for Lloyds Banking Group looks a lot less attractive than from just a few weeks earlier. As a retail lender, its fortunes cannot be disentangled from the pressures faced by its customers or the wider macroeconomic environment.
Although interest rate tailwinds should still be a big driver to a recovery in its pre-provision profitability, it seems for now that the risks are skewed towards the downside.
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