After three years of hardly any growth, the Lloyds (LSE: LLOY) share price has surprised me this year. Last month it came close to breaching 62p, the highest level it’s been since Covid hit in early January 2020.
The price is up 20% so far this year, triple the growth of the FTSE 100 at 6.6%. It’s not the highest in the banking sector though. Both Barclays and NatWest have climbed around 50%.
A recovering UK economy fuelled by falling interest rates has helped drive growth. But as the year progresses, there’s been a growing sense of uncertainty regarding the global economy.
An unclear direction
The US Federal Reserve has reduced interest rates for the first time in four years, with a large half-percentage point cut. US markets have responded positively so far, with the S&P 500 closing up 66.5 points last week.
With one rate cut already done this year, the Bank of England appears to be taking a more cautious approach. The UK economy has had a tough few years so the sensitivity is understandable. However, if the US economy continues to perform well, it may prompt further cuts here.
That could have two potential outcomes for the banking sector.
If interest rates are reduced too rapidly, it could reignite inflation. Moreover, banks like Lloyds rely heavily on loans and mortgages to generate revenue from interest, so lower rates could hurt the bottom line. At the same time, lower rates can also lead to an increase in loan and mortgage applications.
It’s a fragile balancing act that could go either way.
An evolving landscape
Lloyds remains the UK’s largest mortgage lender but according to the bank, demand has been waning recently. So far this hasn’t been reflected in the share price but may bring about lower-than-expected earnings in the next report.
However, the new Labour government could reverse that. It’s pledged to build more affordable housing in an effort to boost homeownership, so an increase in mortgage applications may be imminent.
Lloyds is already showing signs of growth potential. It has a low price-to-earnings (P/E) ratio of 7.9 and earnings are forecast to increase at 5.14% per year going forward. This growth is expected to almost double earnings per share (EPS) over the next two years.
Moreover, dividends are expected to increase even faster than growth, potentially reaching a yield of 6% by 2026. The current dividend payout ratio is only 41%, so there’s certainly room for growth.
One cloud that still hangs over the bank is the vehicle financing saga that came to light at the beginning of the year. As far as I can tell, the full cost of claims related to the probe isn’t clear yet. If it ends up higher than expected, Lloyds could take a hit, financially and reputationally.
The future
Lloyds has been working hard to update its digital capabilities, aimed at improving customer service and the online experience. This could help it to compete with the swathe of new digital banks that are drawing in younger customers.
If the easing of interest rates is well-managed and the economy remains strong, Lloyds looks likely to continue this path of progression. However, the uncertain economic future cannot be downplayed and is a particular risk to the banking sector. I remain cautious.
