The Lloyds Banking Group (LSE:LLOY) share price has risen strongly in recent months. Yet despite the fact that its shares are still appealingly cheap, I can’t help but feel the buzz around the FTSE 100 bank’s unjustified.
Even after recent gains, Lloyds’ shares trade on a forward price-to-earnings (P/E) ratio of 8.7 times. This is comfortably below the Footsie average of around 11 times.
The Black Horse Bank also offers great value when we look at predicted dividends. Its dividend yield of 5.9% is far ahead of the 3.5% FTSE 100 average.
However, I believe Lloyds’ shares are exceptionally cheap for good reason. And there’s a big danger they might sharply correct. Here’s why.
Inflationary pressures
Hopes are high that interest rates will begin to fall in the second half. This reflects expectations that inflation will continue receding, prompting the Bank of England (BoE) to act.
This would be bad for banks by reducing the margins on their lending activities. Lloyds’ own net interest margin (NIM) declined 27 basis points, to 2.95%, during the first quarter as the boost of previous BoE rate hikes weren’t repeated.
However, interest rate cuts could still theoretically be a net positive for banks. They would reduce the possibility of more painful loan impairments, and could help stimulate loan growth.
The danger here is that the BoE benchmark may not fall as sharply as expected if inflation continues to beat forecasts. This has certainly been the trend in recent months.
The latest Consumer Price Inflation (CPI) reading came in at 2.3% in April. This was above a predicted 2.1%, and dashed earlier hopes of a June rate cut.
With wage growth continuing to run hot, higher-than-target inflation could be here for a lot longer than the market anticipates.
Weak economic growth
Continued weakness in the UK economy is another threat to cyclical stocks like banks. Lloyds is the most exposed to this particular phenomenon too, as it sources almost all of its income from these shores.
In fact, recent key data suggests economic conditions are actually worsening. The jobless rate sprang to 4.3% at the end of the first quarter, its highest for almost a year.
Key services industry data is also a tough read for the banks. PMI for the sector — which is responsible for around 80% of total GDP — was 52.9 in April. This was down from 55 in March, and much worse than a predicted modest decline to 54.7.
A continuation of this trend could see all of the UK’s soaring high street banks give back their recent impressive share price gains.
The new PPI scandal?
Anyone like me will have received emails about Lloyds possibly mis-selling motor finance before 2021.
It’s a reminder of the PPI crisis that cost the bank sector billions in the 2010s. And, like that scandal, it has the potential to be an eye-wateringly expensive one.
The Financial Conduct Authority is investigating claims of overcharging by banks, for which Lloyds has set aside £450m to cover potential damages. But the penalties could be even more severe, with some analysts tipping final damages of more than three times that amount.
Lloyds shares have risen despite this threat. But if signs of a new costly scandal grow, the bank could plunge back to earth once again.
