The Lloyds (LSE:LLOY) share price is trading near its 52-week low. This may come as a surprise to those who don’t follow the stock market religiously. But the falling price is because interest rates have extended far beyond levels considered optimal for banks.
So, where will the it go next? Let’s take a closer look.
Interest rate conundrum
Interest rates in the UK are still rising, as they are globally. Inevitably, banks are at the forefront of the effects brought about by monetary tightening.
It’s by no means a simple relationship. However, as the Bank of England raises rates, banks have the ability to increase their net interest margins — the difference between borrowing and savings rates. This has a net positive impact on interest revenue.
However, net interest margins have peaked for several reasons. And now we’re starting to see the headwinds that monetary tightening can bring. This is primarily the threat of mass customer defaults.
When concerns over defaults rise, banks have to put aside more money for impairment charges. In the worse-case scenario, these charges will outweigh the positive impact of higher interest rates.
To date, higher interest rates have had a net positive impact on Lloyds. In H1, income rose 14% to £7bn but the bank put aside £662m for potential bad loans. That figure was a 76% increase versus H1 of 2022.
Interest rates in the driving seat
In the near term, interest rates will likely define the movements we see in the Lloyds share price. This is partly because Lloyds doesn’t have an investment arm and, as such, has greater interest rate sensitivity than other UK banks.
In short, the sooner we see interest rates moderate, the more likely we are to see Lloyds shares push higher.
For banks, there’s an optimal base rate around 2-3%. At such levels we’d expect impairment charges to fall, but interest income will remain elevated versus the last decade.
This is why every piece of economic data is so carefully considered by the market. When PMI data came in lower, Lloyds jumped 0.93%.
However, it’s important to recognise the size of the potential downside. Under Lloyds’ severe negative scenario, the bank forecasts expected credit losses of £10.1bn.
Yet investors might find some peace of mind in the recent UK banks stress test. Lloyds came out as the second-best performer. Under the stress scenario, its CET1 (Common Equity Tier 1) would fall to 11.6%, putting it ahead of all banks bar building society/bank Nationwide.
Valuation is important, and Lloyds is phenomenally cheap. This makes me think that we could see the share price make considerable gains over the medium term.
Currently, Lloyds is trading around 5.2 times forward earnings. That’s far below the index average and below its medium-run average.
It’s also the second cheapest banking stock on the index using the price-to-book ratio, trading at 0.71 times book value.
In turn, this suggest a 29% discount versus the bank’s net asset value. While I appreciate the risks associated with the worst-case scenario, I see this as an undervaluation given the probabilities at play.