Lloyds (LSE:LLOY) shares have been pushed downwards this year as the economic forecast worsened in the UK. At the time of writing, Lloyds is down 13% over the past year. That’s clearly not a great return.
However, despite those economic challenges, and the downward trajectory over the past year, I’m backing Lloyds shares to soar. So let’s find out why.
A sizeable tailwind
Interest rates have been increasing throughout 2022, and will continue increasing through to 2023. Some analysts see the Bank of England (BoE) base rate hitting 4% in 2023. But it could go higher, especially as UK inflation, to date, has shown few signs of slowing.
This is a considerable change for banks. Remember, we’ve had a decade of near zero interest rates, so the current 3% represents a huge shift.
As such, Lloyds’ net interest margins (NIMs) — the difference between savings and lending rates — are rising. Essentially, this means Lloyds isn’t passing on all of the increased lending rates to savers. NIMs are now expected to be above 2.9%.
Lloyds is even earning more interest on the money it leaves with the central bank. And this is a very big money maker for the bank. As of June 30, Lloyds had £145.9bn of eligible assets with £78.3bn held as central bank reserves.
Analysts estimate that each 25 basis point hike in the base rate will add close to £200m in treasury income solely from holdings with the BoE. The base rate has already increased 275 points this year and I’d anticipate another 100 to come.
Lloyds also has greater net interest income (NII) sensitivity than other banks due to its funding composition and business model. For example, Lloyds’ business activities are funded primarily by customer deposits and it doesn’t have an investment arm like its peers in the UK.
Weathering the storm
The economic conditions are putting banks under pressure. During the last quarter, pre-tax profit fell 26% to £1.5bn, primarily due to impairment charges which soared to £668m from a release of £119m a year ago. This fall in profits came despite net income rising 12% to £13bn on the back of surging interest rates.
However, I’m hoping that not all of that money set aside for bad debt will be needed. The recession is not expected to be particularly deep and, hopefully, there will be some upside in the form of falling gas prices.
But in upcoming quarters I’m expecting to see higher revenues having a positive impact on profits as the need to set money aside for bad debts falls.
Buying more Lloyds stock
I’ve owned Lloyds stock for a while, but down 13% over the year, I’m buying more. I see us entering a period of sustained higher interest rates, maybe not as high as 4%, but sustained around 2%. And this will make big a impact to Lloyds’ profitability going forwards.
