UK banks offer relief in slowdown

Investor: An insider's guide to the market Over the next month the financial calendar will be very full with the release of corporate financial results. In the US, the fourth-quarter results season is now in full swing and so far results have been reasonably close to expectations.

For the past three years, the quarterly rate of profit growth of US companies has been remarkably strong. The cumulative impact of this profit buoyancy is that corporate profits in the US now account for a record high proportion of overall national income.

Therefore, the consensus view is that profit growth will slow down considerably this year with the fourth quarter of 2006 marking the beginning of this slowdown.

While the emergence of a slower growth trend is becoming apparent, there are some notable sector variations. Financial sector profits are expected to grow by 37 per cent in the fourth quarter while the energy sector is expected to suffer a decline of 12 per cent due to the falling oil price.

For the rest of the market, earnings are expected to rise by approximately 2 per cent in the fourth quarter. If the US economy achieves the much-talked about soft landing, then corporate profits should advance in 2007 albeit at a modest 2-5 per cent rate. This should be just about enough to support a positive bias to US share prices.

Closer to home, the UK bank reporting season is just getting under way with the main body of reports due for release during February. Despite the Bank of England-inspired interest rate hikes over the past six months, the financial and business climate in the UK remains broadly positive.

Top-line revenue growth should be good as net interest income should benefit from strong loan growth and stable profit margins. Loan growth in 2006 benefited from surprisingly strong growth in the UK mortgage market. This time last year there were widespread fears of a sharp slowdown in housing, but this failed to materialise and the market goes into 2007 in buoyant mood. The mortgage market expanded by 12 per cent in 2006 and with strong house price inflation in an active market, a similar rate of growth is likely in 2007.

Personal lending was slower in 2006 as consumers paid down credit card debt. However, it was a strong year for corporate lending and, with company executives generally optimistic about business conditions, another strong year is in prospect. Trends in non-interest income are also positive with demand for savings and investment products remaining strong.

On the other side of the equation the UK banks continue to exercise good control over costs. Most banks are managing to grow revenues at a faster rate than costs thus ensuring that revenue growth is translated into strong profit growth. The only area that could adversely impact on profit growth is the trend in bad debts. Impairment charges have been rising in UK credit cards and personal loans but otherwise charges for bad debts remain very low. Several banks including Lloyds TSB and Royal Bank of Scotland have indicated that the rate of deterioration in unsecured personal lending is slowing down.

From the perspective of shareholders, the net result in earnings momentum is positive going into 2007 with analysts forecasting earnings per share growth of 10-12 per cent in 2006 and 2007. Given that most UK banks have strong capital ratios, this earnings growth should feed through into dividend growth and possibly further share buybacks.

In this context the UK bank sector looks to be priced very attractively. Barclays, which is capitalised at £49 billion (€74.6 billion), trades on a price earnings ratio (p/e) of just under 10 and offers a prospective dividend yield of 4.6 per cent. Northern Rock, with a market capitalisation of £4.9 billion and growing rapidly, trades on a p/e of 11.4 and offers investors a dividend yield of 3.4 per cent.

These valuations compare favourably with the Irish banks where AIB is trading on a prospective p/e of 11.5 and a dividend yield 3.5 per cent. Faster-growing Anglo Irish Bank trades on a p/e of approximately 14 and a dividend yield of 1.2 per cent.

Although the Irish banks are operating in a faster-growing economy, Investor expects that the lower valuations of the UK banks should enable the UK bank sector to perform at least as well as the Irish bank sector in 2007.