With the economy bracing for inflation fighting interest rate hikes, is now the time to invest in banking stocks?

With rate hikes expected to combat inflation, are UK banking stocks good investments? Or has the potential for profit increases been priced in already?

The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

View of Canary Wharf

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It is almost incomprehensible for the younger generation of investors that there once was a time where banking stocks were considered bastions for solid, safe and secure stock market returns.

In the decade following the financial crisis, investors fled this idea. Performance inconsistency, paired with an increase in regulatory pressures and general uncertainty, this area of financial markets has been a rollercoaster (not an enjoyable one for shareholders).

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Looking at the long-term share price graphs since 2008 for both Barclays and Lloyds Banking Group, it is enough to send shivers down your spine. A sharp decline followed by over the long term, very little (if any) growth from after the crisis, with lots of volatility in between.

However, with the clear need for a change in current monetary policy due to the inflationary environment we are in, rate hikes are inevitable. Put simply, increases in the base rate of interest positively affects banks, allowing them to earn more from lending in comparison to how much they pay on deposits. This should be the single largest factor affecting the performance of banking stocks in 2022.

Headwinds

Fundamentally, this is heavily dependent on rate hikes. Despite being expected by the financial world, the extent of these raises is key to seeing moves in banking stocks’ share prices. Some individuals in the western world, such as legendary investor Bill Ackman, are advocating large raises, with others warning against potential overcorrections and the economic fallout this could cause.

If these raises do occur, especially in a short time frame, I expect to see sudden positive price changes simply due to the increased profits and consequent shareholder returns that go “hand in hand” with this.

Tailwinds

I suspect many cunning Foolish investors will have the same question. Has this all been priced in? There certainly is an argument for this. However, as is always the case when it comes to uncertainty and regulatory announcements, share prices still move with positive news no matter how expected it is. Moreover, too much variation from expectations could also prove to be harmful. Lower-than-expected rate hikes would decrease expected profits as a result the share price will follow the same trajectory. On the flip side, higher-than-expected raises — if extreme — could cause an overcorrection.

It is clear that rate hikes have to be sensible and perceived well to see the rewards for banking stocks in 2022.

Conclusion

The fundamentals of UK banking stocks are solid. In a setting of increased interest rates, I believe they will outperform the market. Despite potentially being largely priced in already, I believe there arestronger gains to come, especially given the market corrections we are seeing currently. While stocks are trading cheap in comparison to a few weeks ago, with a long-term Foolish viewpoint, I think now is the time for me to get in.

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Tommy Williams has no position in any of the shares mentioned. The Motley Fool UK has recommended Barclays and Lloyds Banking Group. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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