Despite the prospects of modest interest rate hikes in the months ahead, the Lloyds (LSE: LLOY) share price continues to underperform. In the last year, it has failed to gain any real traction and has remained stubbornly in a narrow 45p-55p range.
However, with the likelihood of a recession growing, it could be about to get a lot worse for the UK’s largest bank.
Economic outlook
The macroeconomic outlook for the UK in 2022 does not paint a rosy picture. Growth forecasts have been slashed by economists. This is driven by a combination of factors including the war in Ukraine, together with soaring inflation feeding into higher energy and food bills.
The fluid nature of the economic situation means that the information landscape can change very quickly.
In its annual report published only six weeks ago, Lloyds stated that its growth forecasts “assumes no further ‘lockdowns’, that elevated inflation will begin to fall gradually during the second half of the year, and that interest rates will rise only mildly above their pre-pandemic level”. A great deal of uncertainty now surrounds a large part of that statement.
Diversification agenda
One of the biggest criticisms of Lloyds is its one-dimensional business model. Over 75% of its net interest income (NII) comes from retail banking. This includes mortgages, credit cards, and savings.
Lloyds undoubtedly owns iconic, trusted brands within financial services. It’s the largest digital bank with 18m active users. But as digital accelerates, so too does the threat of disintermediation. In today’s hypercompetitive market, companies must work hard to build a compelling, unique value proposition.
Today, the threat to Lloyds comes not from the likes of Barclays and HSBC, but from digital-native, neo-banks. These banks continue to increase their customer base. Although many such business models are unproven and yet to scale successfully, that day could well be just around the corner.
The new CEO has a strategy to diversify its offerings. Its recent acquisition of Embark signals that it wants to grow its business in the highly lucrative and growing wealth management arena. But it is starting from a very low base. Its insurance and wealth division accounts for less than 1% of NII.
Cost structure
One factor Lloyds has in its favour is its industry-leading cost-to-income ratio. This presently stands at 56%. Its aim is for this to be less than 50% by 2026. This it will achieve through a) simplifying its technology estate, and b) enhancing automation and self-service capabilities through customer operations, and c) reducing its office estate in line with hybrid ways of working.
However, accelerating its digital transformation won’t come cheap. Like all traditional banks, its operations still run mostly on legacy systems.
If the UK economy does begin to contract, then Lloyds will undoubtedly bear the full brunt. Improved NII through higher interest rates won’t really come to its rescue if it is accompanied by stagflation.
If modest interest rate rises prove unsuccessful in cooling down red-hot inflation, then more drastic measures will be needed. Highly indebted companies will cut back on their growth ambitions. Consumers will cut spending. And Lloyds will be at the eye of the storm. For me, the risks are simply too great. I won’t be joining its army of private investors.
