How can advisers tell if the West does turn Japanese?

The third-quarter results from the FTSE 100’s Big Five banks generally got a cool reception, not least because of fresh payment protection insurance (PPI) compensation claims and other, assorted legal and conduct costs of £4.6 billion.

As a result, the FTSE All-Share Banks sector is down by 0.4% in 2019 to date, when the FTSE All-Share is up by 9.4%. That leaves the banks ranked just 32 out of the 39 industrial groupings that make up the index.

But the malaise runs deeper than PPI and (mis)conduct fines. They have only added to the UK-based banks’ deep-rooted challenges, namely how the banking market here is mature, competitive and tightly regulated. Throw in a grinding drop in interest rates, bond yields and credit spreads and you have a rotten environment for banks, as their share prices over the last decade will attest, even after all of the hard work put in to cut costs and rebuild their balance sheets.

“Throw in a grinding drop in interest rates, bond yields and credit spreads and you have a rotten environment for banks, as their share prices over the last decade will attest.”


FTSE 100 banks have been a poor pick over the past decade

Source: Refinitiv data, to 1 November 2019

The question now is whether this environment is going to change. As the source of the crisis that engulfed markets 12 years ago, all investors really want to see the banks doing well, as that would help to provide a firm footing for the wider economy, whose wheels would be greased by the credit they provide. Healthy banks would help the stock market too, since consensus analysts’ estimates suggest that the sector will provide 17% of the FTSE 100’s total pre-tax profit for 2020 and 16% of its dividends.

“Healthy banks would help the stock market, since consensus analysts’ estimates suggest that the sector will provide 17% of the FTSE 100’s total pre-tax profit for 2020 and 16% of its dividends.”

Mangled margins

Banks raise money at one interest rate (through deposits or borrowing), lend it out at another and pocket the difference while (hopefully) getting their money back once the loan matures to start the process again. The result is the net interest margin on the loan book and this is a key measure of profitability.

FTSE 100 banks’ net interest margins are still under pressure

Source: Company Accounts. HSBC, RBS and Standard Chartered on left-hand scale, Barclays UK and Lloyds on right-hand scale. RBS restated from Q3 2019 to exclude NatWest Markets.

“The bad news is that banks’ net interest margins are under pressure, for three reasons.”


The bad news is that banks’ net interest margins are under pressure, for three reasons:

  • how interest rates have gone to and stayed near zero, or even gone negative in some areas

  • how the yield curve has flattened

  • how credit spreads have been compressed

  • All three can be seen as an (unintended) consequence of central banks’ zero interest-rate or negative-interest rate policies (ZIRP and NIRP). The chart may not be totally conclusive (investors must also accept that correlation does not mean causation) but the steady flattening of the yield curve in the UK, as benchmarked by the gap between two-year and ten-year Government bonds, does seem to be weighing on the share price performance of the FTSE All-Share Banks sector.

    Era of QE and ZIRP in UK looks to be hurting the banks

    Source: Refinitiv data

    Turning Japanese

    Experienced advisers and clients have seen this before.

    Since its own debt-fuelled property and stock market bubbles burst in 1989, Japan has tried to reinflate valuations and stoke both growth and inflation with NIRP, ZIRP and QE policies, with mixed results. The very fact that the Bank of Japan is still hard at it after nearly three decades hardly smacks of success. Worse, the gradual compression of the same 2s-10s yield curve in Japan looks to have done huge harm to the country’s banks.

    More than 25 years of QE and ZIRP has already hurt Japanese banks

    Source: Refinitiv data

    “The TOPIX Banks index is down by 90% since its all-time high. By comparison, the FTSE All-Share Banks index languishes some 69% below its peak.”


    The TOPIX Banks index is down by 90% since its all-time high. By comparison, the FTSE All-Share Banks index languishes some 69% below its peak. If history repeats itself – and that remains an ‘if’ – then things could get worse for the UK banks before they get better.

    This final graphic shows the performance of the TOPIX Banks index from two years before it peaked to today. It then overlays the performance of the FTSE All-Share Banks index starting on 1 January 2006 – two years before the financial crisis really hit – and then runs it over the same time line as the TOPIX Banks benchmark.

    Japanese lesson warns UK banks could fall further

    Source: Refinitiv data

    This suggests that UK banks could fall further, if QE and ZIRP persist (or NIRP starts) and the Bank of England fails to fire growth and inflation. The past is no certain guide for the future and value-hunting contrarians will note with interest the 270% rally in Japanese banks that ran from 2003 to 2006, when it seemed like Japan was finally breaking out of its deflationary debt trap.

    “Value-hunting contrarians will note with interest the 270% rally in Japanese banks that ran from 2003 to 2006. [… This shows] what could happen […] if sentiment changes and the market begins to believe in inflation rather than fear deflation.”


    That proved to be a false dawn. But it did show what could happen to ‘value’ financial stocks if sentiment changes and advisers and clients begin to believe in inflation rather than fear deflation, so the UK’s banks stocks could be a good way of judging whether the Bank of England is winning in its efforts to fuel inflation and fend off the spectre of deflation.

    AJ Bell Investment Director

    Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.

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