Why Lloyds Banking Group plc is set to beat the FTSE 100 in 2017

Lloyds (LSE: LLOY) has endured a difficult 2016, with the bank’s share price falling by 13% year-to-date. However, it could have been much worse. Investor sentiment in the part-nationalised bank has strengthened after the initial shock of the EU referendum result. And the performance of the UK economy has held up better than forecast in the second half of the year. Despite this, Lloyds has lagged the FTSE 100 by 25% this year. But looking ahead to next year, I feel that the tables could turn.

Brexit challenges

The bank faces problems associated with Brexit. While the UK economy has held up well thus far, heightened uncertainty could become a key theme of the next year. This could lead to downgrades on GDP forecasts and cause profitability at UK-focused banks to come under pressure.

However, Lloyds seems to be well-placed to deal with such Brexit-induced woes. For example, it has spent recent years becoming increasingly efficient and has made numerous job cuts, efficiencies and asset disposals. They’ve positioned the company as a relatively efficient bank among what remains a troubled sector. As such, it may be hit less hard than rivals and investor sentiment may therefore be higher than expected.

The bank’s valuation indicates that the market has already priced-in future difficulties. It trades on a forward price-to-earnings (P/E) ratio of just 9.5, which shows that there’s scope for a significantly higher rating. In fact, even a 50% rise in the bank’s share price would equate to a P/E ratio of just 14.3. With the FTSE 100 being close to its all-time high, it lacks value appeal compared to Lloyds.

Income potential

It’s not just on the valuation front that Lloyds impresses. With inflation forecast to rise to nearly 3% next year, higher yields and growing dividends could become increasingly in vogue. That’s because investors may become concerned at the effect of higher inflation on their incomes, with weaker sterling likely to be a key feature of 2017.

With a yield of 4.9%, Lloyds is a very strong income stock. It’s due to raise dividends by almost 18% in 2017, which puts it on a forward yield of 5.8%. Despite such a large rise in dividends, the bank is still expected to cover its shareholder payouts around 1.8 times next year. This indicates that there’s scope for further rises in future years without jeopardising the company’s growth potential or financial standing.

Index-beating outlook

While 2016 has been a disappointing year for the bank, its prospects for 2017 are very bright. Brexit may cause volatility in its share price, but its improvements as a business in recent years have positioned it well to withstand the difficulties that may present themselves.

The market already seems to have priced-in a difficult outlook, while the income potential on offer over the medium term could create heightened demand for the bank’s shares next year. Therefore, I believe that FTSE 100-beating prospects may be just around the corner.

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Peter Stephens owns shares of Lloyds Banking Group. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.