Since the start of the year, shares in HSBC (LSE: HSBA) have massively outperformed those in Lloyds Banking Group (LSE: LLOY). The price of HSBC shares is up 15.5% year-to-date, compared to a fall of 21.6% for Lloyds, and much of this outperformance has been attributed to the vote for Brexit.
Diverging earnings outlook
Since the EU referendum of 23 June, analyst earnings forecast revisions for the two banks have diverged sharply. Expectations of Lloyds’ earnings have gone down by 6.0% for 2016 and 13.2% for 2017, while HSBC’s expected earnings for HSBC have improved by 3.5% and 0.6%, respectively, for those two years.
Because of Lloyds’ much greater exposure to the UK economy, the Brexit vote has hit the bank hard in two ways. First, slowing growth in the UK economy has hurt the bank’s outlooks for loan demand and credit quality. Second, the Bank of England’s August rate cut will likely reduce the bank’s net interest margins — the spread between what banks make on loans and pay for funding.
HSBC is affected in much the same way, but because of its global diversification, the bank is less exposed to headwinds from the UK market. Meanwhile, because of the falling value of the pound, the sterling value of its overseas earnings have hugely improved since the Brexit vote.
Also, following the disposal of its Brazilian unit and a dividend from its US business, HSBC is buying back some $2.5bn of its shares. This reduces the bank’s outstanding share count, which gives a boost to earnings per share.
However, the weak pound is only likely to be a short-term phenomenon. HSBC’s underlying fundamentals remain weak because of slowing economic growth in emerging markets and its high cost structure. Despite efforts to become more efficient, HSBC has a cost to income ratio of 63.2%, compared to Lloyds’ 47.8%.
Moreover, credit quality is deteriorating faster at HSBC than it is at Lloyds. For the first half of 2016, loan losses rose 64% at HSBC, compared to an increase of 37% at Lloyds for the same period. Lloyds also has a higher CET1 capital ratio – 13.0%, compared to 12.1% for HSBC.
What’s more, with earnings expectations cut back for Lloyds and valuations in the bank already heavily marked down, there is significant upside potential from Lloyds delivering better than expected results. This could come from many things, but will most likely be due to a more-resilient-than-expected UK economy.
It’s quite possible that HSBC will continue to outperform Lloyds for some time. After all, it’s clear that investors are shunning domestically-focused firms in favour of big “dollar-earners” — companies that earn most of their earnings overseas, and which are therefore benefiting from the pound’s weakness.
However, I expect Lloyds to outperform HSBC in the longer run due to its better underlying fundamentals. Valuations for the bank are also more attractive, with shares in Lloyds trading at 8.7 times this year’s expected underlying earnings, compared to HSBC’s multiple of 13.6.