Royal Bank of Scotland Group PLC (LON:RBS) and Lloyds Banking Group PLC (LON:LLOY) have been upgraded by Credit Suisse on the expectation that the UK will see a ‘soft’ Brexit.
Credit Suisse said it believes there is “too much pessimism” about domestic lenders and that it sees the UK headed for a ‘soft’ Brexit with a "high probability of a very long transitional deal, and a rising probability of a second referendum".
“Our central scenario of low growth, low unemployment and moderate (interest) rate rises (from Nov-2017) is supportive for domestic banks’ capital generation and we continue to believe earnings risk is to the upside,” Credit Suisse said.
RBS strengthening its capital buffer
Credit Suisse raised its rating on RBS to ‘neutral’ from ‘underperform’ and lifted its target price to 275p from 225p, saying it welcomes “positive developments on the capital side” and short-term momentum in the business “looks strong”.
In August, at the bank’s first half results, RBS reported its core capital ratio rose by 70 basis points to 14.8%, ahead of its 13.0% target. The lender said new accounting standards known as IFRS 9 due to be implemented in January would have boosted that ratio by a further 0.3 percentage points if included at the time.
“We believe this provides some further buffer against litigation risk, mainly from the US Department of Justice,” Credit Suisse said.
The bank, which is still more than 70% owned by the taxpayer, is facing another hefty penalty related to the mortgage-backed securities misselling scandal after it concludes negotiations with the US Department of Justice.
Credit Suisse added that RBS has enjoyed 30% upgrades to consensus forward earnings per share (EPS) estimates in the year to date, largely driven by the better outcome for its Williams & Glyn branches. The bank seems to have avoided a forced sale of its struggling Williams & Glyn business after the European Commission accepted an alternative proposal to set up a fund for challenger banks.
However, Credit Suisse said it continues to see uncertainties in the timing of capital return and risks to its UK growth strategy such as price competition. It also it remains unclear when the DoJ case will be settled.
Lloyds the 'likely winner of a soft Brexit'
On Lloyds, Credit Suisse raised its rating to ‘outperform’ from ‘neutral’ and increased the target price to 80p from 75p.
“This follows adjusted EPS upgrades of 11%/4%/3% for 2017/18/19 from robust asset quality and higher revenues,” Credit Suisse said.
“We have also upgraded our final dividend for 2017 to 3.0p from 2.75p; representing a 4.5% yield (6.7% FY18E) on expectations of a more manageable IFRS 9 impact (estimated 40 basis points gross).”
Credit Suisse thinks Lloyds is the likely winner on an expected “soft transition” of Brexit from 2019 until at least 2021.
The broker noted that Lloyds shares have de-rated relative to UK peers in the year to date. The lender has seen EPS consensus upgrades of 20% for 2018 compared with just a 9% rise in the share price while international UK banks have re-rated on more modest earnings upgrades.
“We would expect this domestic UK risk-premium to reduce as 1) a softer Brexit becomes the market base case and 2) Lloyds’ earnings and capital generation remain supportive,” Credit Suisse said.
Credit Suisse also believes concerns about the net interest margin being under pressure are “overdone”. It said it is broadly in line with guidance for fiscal year of “close to 2.85%” at 2.84% and expects “moderate expansion” in 2018-19, driven by the full benefit of the acquisition on credit card business MBNA, reaching 2.89% for fiscal year 2019.
Barclays most sensitive to US tax changes
Elsewhere in the UK banking sector, Credit Suisse left its rating on Barclays PLC (LON:BARC) at ‘outperform’ but cut its target price to 230p from 250p.
“We believe market sentiment towards the stock is too depressed, given the improvements in capital, and there is upside should volatility return to the capital markets or if the US administration's tax proposals become reality,” Credit Suisse said.
It sees further capital benefit coming through in the second half of the year with the common tier 1 ratio boosted 25-30 basis points by the deconsolidation of its Africa business.
Credit Suisse also expects about an 8% benefit to EPS if the US tax rate falls to 20% from 35% as proposed by the Trump administration. "On our estimates, Barclays’ has the largest earnings benefit (among the large UK banks) from potentially lower US tax rates; it has the highest US contribution to group earnings (CS estimate of 30-35%)."
HSBC downgraded to 'underperform'
HSBC Holdings PLC (LON:HSBA) saw its rating downgraded to ‘underperform’ from ‘neutral’ but its target price lifted to 650p from 630p by Credit Suisse.
While HSBC’s shares have outperformed domestic peers by 10% in the year to date, earnings revisions have lagged by about 5% on average.
“We think investor sentiment towards UK domestic bank stocks should improve over the next 12 months as a soft Brexit becomes more likely, reversing some of HSBC's post-Brexit vote share price gains,” Credit Suisse said.
HSBC is the most sensitive of the UK banks to interest rates but that the outlook for rates varies considerably for its key currencies, Credit Suisse added.
US rate expectations have fallen since the peak in March and Hong Kong rates continue to lag while the UK is improving from a low base, it said.
Standard Chartered continues to face challenges in wholesale banking
On Standard Chartered, Credit Suisse reiterated an ‘underperform’ rating and lifted its target price to 620p from 615p, saying it continues to believe current valuations of earnings are “too generous” given the returns outlook and ongoing uncertainty on top-line growth.
Credit Suisse said the common equity tier 1 ratio could dip to 13.0% by the year ended 2020 compared to 14.3% in its base case if margins remain flat in 2017 and the group had to use risk weighted assets growth to maintain revenues.
Standard Chartered also continues to contend with challenges in wholesale banking as it invests in re-establishing leadership in tis Financial Markets business. “…We think this is a challenging environment in which to show progress, given the overall low volatility in financial markets,” Credit Suisse said.