The Long-Term Opportunity Emerging From Britain’s Rising Interest Rates

The Long-Term Opportunity Emerging From Britain’s Rising Interest Rates
Carl Hazeley

about 2 years ago3 mins

  • Economists are expecting the Bank of England to increase UK interest rates to 1.75% by next year.

  • Higher interest rates are good news for banks, and could result in a doubling of their profits, all else being equal.

  • According to Goldman Sachs, British banks NatWest, Lloyds, and Barclays screen as attractive long-term investments that’ll allow you to benefit.

Economists are expecting the Bank of England to increase UK interest rates to 1.75% by next year.

Higher interest rates are good news for banks, and could result in a doubling of their profits, all else being equal.

According to Goldman Sachs, British banks NatWest, Lloyds, and Barclays screen as attractive long-term investments that’ll allow you to benefit.

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It’s hard not to get caught up in the short-term prospects of markets right now: most investors are, after all, fixated on the immediate impact of the Russia-Ukraine crisis. But this could serve as the reminder you need to take positions that’ll bolster your portfolio for the long term, and recent analysis from Goldman Sachs suggest there might be a great one on offer: British banks.

What’s going on here?

The Bank of England has already raised UK interest rates once this year, and economists are convinced it’ll keep going. In fact, Goldman Sachs is expecting Britain’s “base rate” to rise from 0.5% now to 1% by May, and to 1.75% by next year.

UK rate expectations. Source: Goldman Sachs, Bloomberg.
UK rate expectations. Source: Goldman Sachs, Bloomberg.

This is important for British banks because their earnings tend to move in the same direction as the country’s interest rates – they’re “highly geared”. Banks like Lloyds and NatWest, for instance, could see their pre-tax profits double if rates go to 1.75%.

As for how, it’s partly down to something called the “deposit beta” – the relationship between interest rates and the amount of interest banks pay savers. Between 2017 and 2018, for example, UK interest rates increased from 0.25% to 0.75%, and the rates savers were paid on their cash rose by less than 0.2%. That meant the deposit beta – which is historically around 40% – was 60%. That is, banks were able to capture 60% of the benefit of higher rates for themselves.

This time around, there may not be much need for UK banks to compete for savers’ cash by raising the interest they offer, since their customers already have a lot of money sitting in their bank accounts. That would mean a lower deposit beta, which would in turn mean that banks are likely to keep more of the benefit of higher rates, rather than pass the profits onto their customers.

On the flip-side, of course, a market full of cash-rich savers creates competition between banks for things like mortgages. Banks, then, might hold off on passing higher rates onto customers in hopes of winning over homeowners from rivals, and in doing so lock in lower profits than they could otherwise earn. So with that downside in mind as well as the upside potential, both Lloyds and NatWest are likely to see an overall uplift of 70% in pre-tax profits.

What’s the opportunity here?

According to Goldman Sachs, this profit potential isn’t reflected in current valuations. Take NatWest: it’s trading on a 0.92x price-to-tangible book value multiple (i.e. its value relative to the tangible assets it has), while offering a 2023 return on tangible equity (a key profitability metric for banks) of 10.4%, rising to 12.4% in 2025. This screens as attractive, especially considering that the bank is sitting on excess cash worth 26% of its market value.

But before piling into NatWest, Lloyds, or even Barclays (which also screens positively), you should know you'll need to be willing to wait for profits. This is very much a long-term opportunity: only 40% of the benefit of higher interest rates will have come through to NatWest’s bottom line by 2025, with the full impact only arriving in 2028-2029. That’s due to the “structural hedging” banks do to make sure their profits don’t swing around wildly: they can predict their income pretty accurately by locking in interest rates for a while, and give their shareholders peace of mind.

Still though, I wouldn’t necessarily wait before investing. Stock markets are notoriously forward-looking and quick to price in future earnings expectations. So if and when UK interest rates continue to rise, banks’ profit increases become more and more certain – and their shares likely more appealing to investors.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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