Lloyds (LSE:LLOY) shares are down 6% over the month, despite the bank smashing forecasts in its Q1 results — published on 3 May. So why is this? Well, in short, there are certainly a few commentators suggesting this is the best it’s going to get for Lloyds. It’s all downhill from here, they say.
But I don’t see it that way. I definitely don’t think investors should avoid Lloyds stock. In fact, I’ve been buying more as the share price has pushed downwards. So let’s take a closer look at why I’m ignoring the pessimists.
What the results told us
Last week, Lloyds posted first-quarter pre-tax profit of £2.26bn, up 46% year on year, and better than the £1.95bn average of analyst forecasts. Underlying net interest income rose 20% in the first quarter, and net interest margins hit 3.22%. Clearly, this is very positive.
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A big gain versus the estimates came in the form of impairment charges. Lloyds increased bad loan provisions to £243m to cover potential losses, but this was far below the £356m forecast by analysts.
However, it’s worth highlighting that bad loan provisions were considerably above the same period last year — £177m. Lloyds said it expects full-year net interest margins would be above 3.05%.
The interest rates issue
Matt Britzman, equity analyst at Hargreaves Lansdown, said that “things are likely to get tougher from here, arguably more so for banks like Lloyds with high-interest rate sensitivity“.
Higher interest rates obviously have a positive impact on bank revenues. So some investors think that falling interest rates will be negative for banks.
However, when rates get very high, like the ones we can see today, there are negative repercussions — namely higher customer defaults and therefore higher impairment costs.
As such, there’s an ideal level for interest rates, somewhere around 2% and 3%. In such an environment, we can expect impairment charges to fall from their current rates, but interest revenue will remain elevated versus the last decade.
Here’s what coming
In the medium term, the market expects central bank interest rates to fall to around 2-3%. In such an environment, assuming the economy isn’t in freefall, Lloyds won’t have impairment charges anywhere as large as they are today, and interest revenue will be lower but still considerable. It’s also worth highlighting that lower interest rates will likely contribute to greater loan book growth.
In fact, my biggest concerns are in the near term. I’ve been slightly reassured by impairment charges coming in lower than anticipated in Q1, but there could be more pain to come. With interest rates set to rise further in the very near term, and a continuing cost-of-living crisis, the number of Britons struggling with loan or mortgage repayments could grow.
As such, I see several benefits to interest rates falling in the medium term. So much so that I’d say I’m buying Lloyds shares now for falling rates, not because the bank is beating expectations.
Valuation makes this bank an even sweeter proposition. The company trades at just six times earnings, making it one of the cheapest banks in the UK.
