The outlook for the UK banking sector is extremely challenging. Brexit is expected to cause an economic slowdown, with the Bank of England downgrading its forecast growth rate from 2.3% to just 0.8% for 2017, which indicates that things could get worse before they get better.
This is bad news for challenger banks such as Virgin Money (LSE: VM). It’s UK-focused and its shares have fallen by 24% since the EU referendum, having previously benefitted from rising demand for loans as the UK economy moved from strength to strength. Increasing house prices also led to greater demand for property and Virgin Money was able to generate strong profitability as a result.
However, with the Bank of England now predicting a fall in house prices, demand for property is likely to fall. Similarly, greater job insecurity and the prospect of a higher unemployment rate is likely to hurt demand for new loans and cause a rise in defaults on existing loans. Certainly, the Bank of England’s reduction in interest rates may help, but it may not be enough to allow Virgin Money to record a rapidly rising bottom line over the near term.
One solution is to buy shares in a bank with little or no exposure to the UK economy. One such is Standard Chartered (LSE: STAN), which isAsia-focused. This provides it with stunning long-term growth potential, with demand for consumer discretionary products (including financial services) expected to rise by 7% per annum between now and 2020. Furthermore, financial product penetration in Asia is relatively low and with an ageing population, demand for savings and pension products is likely to be high.
Standard Chartered is, of course, in the midst of a major turnaround following a challenging period. While this increases its risk profile, it also means that the potential rewards are higher since the bank’s strategy to focus on compliance and improve efficiencies means it’s set to record a rise in earnings of 124% in the next financial year. This puts it on a price-to-earnings growth (PEG) ratio of 0.1, which indicates that it’s an excellent buy.
However, the UK economy shouldn’t be ruled out completely. It may be about to endure a tough period but its long-term potential remains bright. Therefore, buying a bank with some exposure to the UK, but which also has a global presence may be a shrewd move. That could mean Barclays (LSE: BARC), which has a new management team that has already cut dividends to improve its financial standing.
It’s also seeking to make asset disposals as well as further efficiencies to boost profitability, with earnings forecast to rise by 51% in the next financial year. This puts Barclays on a PEG ratio of 0.2 and while this is higher than Standard Chartered’s PEG ratio of 0.1, Barclays has a more stable business model as well as greater diversity. This reduces its risk profile and makes it a better buy than Standard Chartered.
Barclays has the size and scale to cope with a severe downturn in the UK economy. While Virgin Money could likewise survive, its less diversified product offering, lack of size and scale compared to Barclays and its UK-focus all mean that Barclays offers a superior risk/reward ratio at the present time.
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Peter Stephens owns shares of Barclays and Standard Chartered. The Motley Fool UK has recommended Barclays. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.