Is rising inflation good for UK banks?

Right now inflation is running riot and it seems we have no way to control it, supply chains are stretched and demand remains high. Employment is low and wage demand is on the up. Blimey, even state pensions are being increased by 10% next year to keep them in line with inflation.

Over the last couple of decades shares have been a way of keeping ahead, with inflation hovering at around 2% or less and some shares often yielding 5%, and the potential for growth with large blue-chip (minimum risk) companies, why not? The one thing you did know was that leaving any savings in a bank account was actually costing you money!

During low inflationary times, one sector that can struggle is the banking industry. After all, in simple terms banks hold accounts of people’s savings and lend money to other folk who need it, in return these people either gain interest (savers) or pay interest (borrowers). If inflation is low then interest rates are low to promote growth and when they are low banks are limited on the breadth of interest they are paying and charging.

So with inflation on the march, I’m going to look at the UK banking sector and look into which company or companies are best placed and which to invest in and why.

I’ll cover five companies, Lloyds (LLOY), Barclays (BARC), Natwest (NWG), Standard Chartered (STAN) and an outlier Virgin Money (VMUK).

What return will I get?

The first thing to look at is the current yield and whether or not this payment is safe (relatively speaking). The below table is in no particular order and clearly (to me at least) indicates that all of these institutions are being quite conservative with dividend payments as it stands, even the lowest cover at more than two and a half times is in theory pretty safe.

This table shows that both STAN & VMUK are paying a low dividend by comparison, with both companies cutting dividend payments in 2019. VMUK didn’t pay out a penny in both 2019 & 2020 and in 2021 paid out a dividend that was a third of the payment in 2018. STAN cut its dividend down to a third from 2018 to 2019 and has been cautiously rising it each year since. Note both of these cuts were ahead of the Coronavirus pandemic.

The other three, LLOY, BARC & NWG are pretty much in line with each other but the combination with the safety net of more than seven times stands out for BARC. Since the pandemic all of these companies cut their dividend, LLOY are gaining ground quickly but are still not back at pre-pandemic levels. BARC are pretty much matching the 2018 pay-out and NWG have smashed it and are already paying out more to shareholders than they did pre-pandemic, thus the lower dividend cover.

Which company is the best value?

A simple barometer for value is the price-to-earnings (P/E) ratio and it’s always one of the first things to look for. So below is another bland table for you.

All of the above price-to-earnings look… really cheap, perhaps concern is already priced into this sector? I would have said that in previous years a P/E of ten would likely not be considered expensive for a bank stock, so all of the above seem to be good value at present.

Market vs Book

Another good indication, the price-to-book (P/B) ratio is again another sign that these companies are good value at present. Dull as dishwater table below.

All of the above P/B values tell us that the current share price appears to offer good value. You could pretty much purchase any of the above and on paper you’ve doubled your money, but should this be a concern? Has the market priced in worrying times ahead? Obviously, bank assets differ somewhat from a normal business, they include physical assets and investments but they also include loans. On paper, these loans are predicted to contribute to the company’s fortunes but they have to be repaid for the bank to make money and this is a risk, perhaps more now than previously.

Should we all buy?

I suppose the answer to this depends on whether you think the UK is heading for a recession and if so how long and how bad this will be. Alternatively, can the UK government and bank of England manage to find a soft landing somehow? Essentially, if inflation is contained and the economy is picking up, banks should find things easier and make more profit. However, if we have a downturn and inflation remains high then we could see a return of large-scale mortgage defaults similar to the 1990s, not so good for banks.

At this stage, I am personally considering increasing shareholdings of Barclays, Lloyds or potentially Virgin Money. This is based on reasonable yield (although VMUK is on the low side) combined with good dividend cover. A very low price-earnings ratio and a great price-book ratio. I am putting Natwest and Standard Chartered to one side for the time being. So let’s look into the 3 companies that remain in more detail, our summarise with bullets below.

Sector Analysis

Even with the challenger banks I don’t think that the big players are going anyway and competition is always a good thing in my view. I’m also pretty confident that with inflation rising and interest rates likely to be following along this is a positive for banks. However, if taking the potential economic pain of covid-19, the war in Europe caused by Russia invading Ukraine, the current turmoil within UK government meaning potential short-term and potentially short-sighted changes to economic policy… will all of these add up to a worsening economic outlook for the UK? The answer to this is likely a yes, so is buying into any of these banks a good idea? I think in the short term we could see a reduction in the share values of banks, in fact, this uncertainty may already be priced in but there is a risk of further falls.

If I buy or at least buy a batch now I.e. buy smaller chunks say over several months rather than buy in one lump then I reduce the risk and as shown above I would be buying at what appears to be a “good value”, and if anything profits could pick-up with higher interest rates. Obviously, with inflation hovering around 10% and only taking the dividends into account I’m making a loss of say 5% straight off the bat, if share values fall then that’s going to seem like a kick in the face. However, if inflation turns out to be a short-term issue and inflation returns to the targeted 2%. Then the likely outcome is a P/E closer to 10 on a higher share price, with dividends remaining around the 5% mark.

Banks are not classed as a growth stock – more an income stock or at present a value stock, but at present, they have in the short-term at least become a growth stock as far as I can tell, they could potentially grow in value and then stick with the income stock model. This would mean that buying in now would lock in the price and therefore a higher than 5% yield in the future.

Conclusion

After clicking through pages of information and looking for any other scares or negative points of discussion on the internet I’ve added some more Barclays shares, I really wanted to buy some Lloyds as well but couldn’t bring myself to click the button and buy as I already have a large proportion of my portfolio in this sector and particularly with Lloyds. I do think they’re an excellent investment but before taking the plunge I’m going to adjust the proportions of other sectors to de-risk somewhat given the potential economic outlook.