Keep an eye on banks’ loan books

It may be ten years since the Global Financial Crisis came to an end (or at least stock markets bottomed, to use them as a crude proxy), but the after-effects continue to linger. This can be seen most clearly in the performance of the banking sector, in the UK and also worldwide.

In 2019, the Banks sector is the ninth-worst performing sector within the FTSE All-Share, with a 4.7% capital gain that lags the index by several percentage points.

Ten best and worst performing sectors in FTSE All-Share, 2019 to date

Source: Refinitiv data, as of 2 August 2019

But this poor stock market showing is not unique to Britain’s lenders. America’s Philadelphia KBW banks index topped out last summer and Europe’s STOXX banks index is trading at not just a 12-month trough, but its lowest level since 1995.

US and European banking indices are performing poorly too

Source: Refinitiv data

The woes of Europe’s banks may be best encapsulated by the grinding drop in Deutsche Bank’s share price, but its woes are in many ways related to its investment bank and that unit’s derivatives book. Chief executive Christian Sewing is looking to downsize that business by culling 18,000 jobs and the equities operations, and that plan is offering some respite – at least temporarily – to Deutsche’s share price (something that may make the senior management team at Barclays twitch just a little, given their ongoing commitment to the investment bank there).

Advisers and clients are unlikely to have the time to keep up with stock-specific issues, even for a bank as systemically important as Deutsche. On a sector basis, the real issue may in fact be non-performing loans (NPLs). Worryingly, the FTSE 100’s Big Five banks now seem to be showing a worsening trend here too. And while the good news is they are starting from a low base, the bad news is that loan impairments seem to be past the trough and trending higher. Investors need to pay attention because if this does become a hard and fast trend, then it could have negative implications for the banking sector and also the wider economy, as a real uptick in loan losses would suggest the economy is not in good health. We shall see.

Loan book blues

In Europe, the problem of NPLs seems stark. While the situation has improved since 2016, European Central Bank (ECB) data suggests that 44% of banks loans in Greece, 22% in Cyprus, 11% in Portugal and nearly 10% in Italy are non-performing. The ECB also suggests that more than half of these dud loans are over two years old and a quarter are at least five years old.

This is when the Eurozone is still growing. Heaven knows what might happen if the economy turns down and a new recession develops, as the resulting jump in NPLs could presumably knock a big hole in the banks’ balance sheets, further crimping their ability to lend and so oil the economy’s wheels.

European non-performing loan data remains a concern

Source: European Central Bank, Consolidated Banking Data. Calculations by Commission services (DG FISMA), for Q3 2018

Investors looking for cheer will see the UK near the bottom of the list with an NPL ratio of just 1.2%.

Those who lean more toward the dark side will be noting with interest a trend toward higher credit losses and impairments. Standard Chartered (STAN) did not see a deterioration in the first half of 2019 relative to a year ago, but its fellow Asian heavyweight HSBC (HSBA) did.

UK’s emerging market-focused duo showing a rising trend in loan losses …

Source: Company accounts

So did the more domestically-focused trio of Barclays (BARC), Lloyds (LLOY) and Royal Bank of Scotland (RBS).

… and so are the more UK-centric big three

Source: Company accounts

Early days

While such details are likely to be beyond the remit of any advisers and the attention span of a time-pressed, information-swamped client, there is at least no need to press the panic button. The loan impairment ratio at the Big Five ranges from 0.17% at Standard Chartered to 0.54% at Barclays.

But the rise in losses does look ominous and this could have portfolio implications. After all, the Big Five banks are forecast by analysts to generate 17% of the FTSE 100’s total pre-tax profit in 2019 and pay out 15% of its dividends (excluding special dividends). More tellingly still, the lenders are forecast to provide nearly a quarter of earnings growth and a third of dividend growth in 2019.

If the banks falter, then the FTSE 100 could feel the effects too and the signs of an increase in NPLs must be watched.

It could suggest that the global economy is not in quite the rude health we would like to think it is. It could also explain why central banks are backtracking on interest rate rises and leaning toward cuts, as even a modest tightening of policy looks to be making borrowers’ ability to pay coupons and repay principal more difficult.

To reassure on all fronts, it would be nice to see loan losses moderate and the banking stocks offer improved financial and share price performance in the second half of 2019 and beyond.

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.