Why Lloyds Bank and NatWest shares have just been upgraded

There’s uncertainty about UK interest rate rises, but analysts are upbeat about prospects for an eventual recovery in fortunes for the sector, reports our City expert.

Bank shares today remained in the slow lane of the FTSE 100 index, despite support for NatWest (LSE:NWG) andLloyds Banking Group (LSE:LLOY) in a sector tipped to see big capital returns.

The UK lenders are some way short of matching the feat of the wider blue-chip index, which is already back to where it was prior to the Omicron sell-off in late November. The uncertain outlook for Bank of England interest rates is largely to blame for the slow progress, with the Lloyds price of 47.3p still 5% lower than before the Black Friday rout.

However, analysts at Deutsche Bank remain optimistic for an eventual recovery in fortunes, after they increased their price target on “Top Pick” Lloyds by 3p to 63p and lifted NatWest to a “buy” recommendation with a 40p higher target price at 300p.

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Today's report sees a 31% average upside across the sector, based on the current lowly multiple of 6.2 times 2024 earnings. Barclays (LSE:BARC) has been downgraded from “buy” to “hold”, even though there's still substantial potential upside to 240p from today's price of 186p.

Deutsche Bank's forecasts are based on substantial net interest income growth over the next three years, as UK interest rates finally accelerate away from their emergency 0.1% low. Today's note said: “UK and Irish banks have some of the best revenue momentum in Europe due to rates — and we believe this should have a higher value over time.”

Against this backdrop, it thinks capital returns will be significant based on a combined 15% total dividend yield and another 11% in buybacks over the next three years. Even then, the banks will still have excess capital equivalent to 16% of market capitalisation.

NatWest, which is the most rate-sensitive of the UK banks, offers the highest forecast return based on excess capital at a sector-leading 35%, followed by Lloyds and Barclays at 26%.

Deutsche Bank expects revenue momentum for HSBC (LSE:HSBA) and Standard Chartered (LSE:STAN) to pick up pace in 2023 and eventually overtake the domestic banks, due to the later impact of US rate rises. HSBC has been upgraded from “sell” to “hold” with a 90p higher target price at 480p, while Asia-focused Standard is now at 610p compared with 560p previously.

Further clarity on medium-term guidance is likely to come in February's full-year results season, where the outlook should be supported by higher rates and low unemployment.

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Today's report said: “The economic outlook is arguably better than it was in 2019 and there has been a substantial mix shift across the banks into mortgages in the last two years. We expect new guidance to reflect the improved economic environment and for the mix shift to lead to lower margin, lower cost of risk and lower capital consumption business plans.”

One big uncertainty surrounds wage inflation and whether banks can continue to find the efficiencies they need to offset these pressures.

Deutsche Bank said: “Consensus downgrades to costs in 2022 is the highest risk in the short term for UK banks. HSBC, Virgin Money (LSE:VMUK) and AIB (LSE:AIBG) have already given updated cost guidance, and Standard Chartered guides to costs rising but below consensus. Our bigger concerns are for Lloyds, Barclays and NatWest.”