Lloyds Banking Group's (LON:LLOY) performance in the first quarter will soften some scepticism over its ability to meet ambitious targets for this year and those ahead.
Strength to strength
Having announced, at the end of its 2016 financial year, a 2.7% net interest margin for this one, the group has now set its sights higher to 2.8%, and that’s without the recently acquired credit card business MBNA.
Furthermore, the group sticks to the 45% cost: income ratio goal. There’s nothing in Thursday’s statement that suggests the group is any less certain it can redouble efforts to rebalance its cost structure. That’s despite the ratio lengthening its lead against those of LBG’s rivals, which averaged 60.7% in 2016, by 160 basis points to 47.1. It’s possible the last 2.1 percentage points to the target will be more difficult to cross and sustain. So far though, Lloyds’s CEO has consistently outperformed expectations with respect to identification of cost reduction opportunities, and an additional 50 basis points, say, before the year end, does not seem a stretch.
Lloyds also remains ahead of United Kingdom peers in terms of the key acid test of capital strength—Common Equity Tier 1 (CET1) ratio. That advanced 50 basis points from 13.8% at end-2016 to 14.3% by the end of March, net of dividends paid out by Lloyds Bank’s insurance business, and 14.5% before the unit’s pay-out in February. That underscores signs that the market view of the group’s financial strength is beginning to look out of date. For instance, the average CET1 view of LBG’s fiscal year, according to Thomson Reuters data is still 12.6%. Investors are no doubt factoring in economic road bumps, but even then, the disparity looks increasingly incongruous.
Mortgage market mission
A search for signs of potential coming stress at another crucial watch point for the bank, which is Britain’s biggest mortgage lender, also turns up few concerns for the moment. The notion that competition for mortgages will intensify to the detriment of Lloyds in one of the few remaining markets of at least modest growth for competitors, isn’t particularly well backed. “Some contraction” in open and closed mortgage portfolios was accompanied by a continuing decline in ‘open book’ mortgages during the quarter. But Lloyds' forecasts some stabilisation later in the year, with growth near year-end to match that of the year before.
It’s not quite a picture of a mortgage lender beset on all sides by rivals. And we do not expect rivals to be any less immune to the net margin compression that mortgage lenders can be exposed to due to use of swap rates to hedge, particularly with pricing flat-to-lower. (The income impact may partly be offset by the BoE’s Term Funding Scheme). The mortgage business outlook Lloyds offers and other anecdotal soundings are more consistent in our view with retention of market share by LBG in the sector into year-end. That said the proportion of lenders that are going without hedging of new originations is unclear.
The unmentioned
Either way we think investors should now feel more compelled to read Lloyds’ progress on return on tangible equity more optimistically, albeit with due sceptical grit. The bank is now after all the UK-facing lender closest to achieving a threshold of returns that is widely thought to afford consistent economic profits in British banking— around 10%. With an 8.8% statutory RoTE at the end of Q1 and 15.1% on an underlying basis, Lloyds’s path to that goal looks more plausible than its closest rivals RBS (LON:RBS) and Barclays (LON:BARC).
The one factor which the bank skims over in its quarterly update is of course Brexit (the word is absent from the entire report and “referendum” only appears in the boilerplate regulatory caution about forward-looking statements). Lloyds, like RBS and to a lesser extent Barclays, can’t escape the revenue suppressing effect of a weak sterling, and there’s no guarantee that the pound can carry its near 5% revival so far this year even into the third quarter.
The notion of a cool-down in UK consumption is increasingly difficult to dismiss, partly driven by signs that inflation may soon cross the business threshold into the high street. That suggests further progress by Lloyds to its key targets will depend more and more on Britain’s ability to keep its nerve (and Westminster’s negotiating skill) as the pain of the divorce from the EU steadily mounts.
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