In the UK, inflation is currently running at 9.1%. The Bank of England has warned that it could hit 11% later this year. With few signs that it’s going to get back to the 2% target rate for a long time, I want to look at stocks that could perform well in this environment. Lloyds Banking Group (LSE:LLOY) might not be the first stock that pops out in this case. However, here’s why I think the Lloyds share price could move up with higher inflation.
Thinking out loud
My argument hinges on the assumption that the Bank of England will raise interest rates continually to try and stem the high inflation. This is what the central bank has been doing so far this year. Interest rates have popped higher to 1.25%, with steady 0.25% hikes at each meeting.
With inflation continuing to climb, I’d expect another rate increase next month, this time by 0.5%. From there, I think that we could have a base rate easily above 2% by the end of the year.
But what’s the connection between higher rates and profitability for Lloyds? The main way that a bank makes money is through net interest income. This income reflects the net interest margin made. The margin is the difference between the rate paid on deposits, versus the rate charged on loans.
The higher the base rate is, the larger the margin (and income) the bank makes. Even at 1.25%, most cash accounts are still paying sub 0.25% interest. So the margin in this area has grown massively in just the past year. This income should filter through later this year to higher profitability.
Recession concerns noted
Some would cite a big risk to my view about Lloyds shares appreciating due to a potential recession. The cost of living crisis with high energy bills is also impacted by inflation being above average.
Such a recession could cause people to cut back on spending and hoard cash deposits as much as possible.
Even though the Lloyds share price might take a hit from the broader stock market falling, I still think fundamentals would support it. Higher deposits would help to further increase the net interest margin. Even though provisions would need to be made for loan defaults, the higher issuance of loans would generate revenue.
So even with high inflation potentially damaging the overall UK economy further down the line, I don’t see this as a material risk for the performance of the bank.
Taking advantage of the Lloyds share price
The share price has fallen by 10% over the past year, putting the price-to-earnings ratio down to 5.59. At 41.8p, it’s also close to the 52 week low of 38p. This gives me more of a buffer room to consider investing now, as I think the stock is already close to being undervalued.
If the company was trading at record highs, my theory around inflation might seem too left field to warrant putting my money where my mouth was. But in this case, I’m happy to invest now as I feel further downside is limited, whereas the move higher could be significant.
