Unsteady recovery for banks

In spite of the US government’s takeover of mortgage giants Fannie Mae and Freddie Mac and the subsequent rally in UK bank stocks earlier this week, the mood of analysts and fund managers towards the financials sector remains sombre.

UK financial stocks soared on Monday by more than 10 per cent, but were swiftly brought back to earth by Lehman Brothers’ results on Wednesday, and a warning on Thursday from Mervyn King, governor of the Bank of England, that help from the Bank would not solve the funding shortage faced by mortgage lenders.

A note from Sandy Chen, banking analyst at Panmure Gordon, sums up the view: “All the fundamental drivers for the credit crunch are still very much in place, and we do not see the US bailout [of Fannie Mae and Freddie Mac] changing that.”

Analysts at Credit Suisse give a number of reasons to justify the title of their note: “Banks: the time is not right”, including the observation that the last time banks led a bear market in 1989, they did not lead the recovery.

“I think there’s been a lot of hopefulness in the bank stocks and people are now realising that was a bit premature,” says James Clunie, investment director at SWIP.

Investment managers have been weighing up two contrasting views. One is that financial stocks are historically cheap, based on fundamental measures, making them a possible buy for the long term. The other is that there could be more bad news to come in the short term.

As Charles MacKinnon, chief investment officer at Thurleigh Investment Managers, points out, one effect of the US bailout could be to free up liquidity to the extent that banks are able to offload assets at reduced values – causing their shares to fall further.

There is also concern that the banks have yet to see – or reveal – the impact of bad debt from consumers. “I think people will realise there is still a vast amount of toxic waste sitting inside these banks,” warns MacKinnon.

However, some fund managers are looking for stocks that they feel offer long-term growth potential.

For example, Royal Bank of Scotland is cited by some managers as a “buy”, thanks to its relatively successful capital raising in June and what are seen as realistic writedowns announced in August.

HSBC remains the most favoured bank stock because of its global reach – it is also the best capitalised and most attractively diversified, say managers. “The potential returns are probably less with HSBC in the next year or so but the risks are much less as well,” says Neil Tong, UK large cap portfolio manager at Alliance Trust.

Some managers say they are avoiding banks that are particularly exposed to the UK economy, such as HBOS, or smaller banks such as Bradford & Bingley, because of the gloomy economic outlook. But others believe HBOS is a buy. Analysts at Goldman Sachs said this week that the concerns were more than priced in, and that they believed HBOS to be the most strongly capitalised domestic UK bank.

But valuation arguments do not hold sway with all investors. Julian Chillingworth, chief investment officer at Rathbones, says: “They may well be undervalued but they could stay that way for a long time. There is an argument you should always buy banks well under book value – as with RBS – but it depends on how you value book value. That’s not precise. It’s your view on how much more pain they will have to take. In the current environment, you don’t need that level of risk.”