The Lloyds (LSE:LLOY) share price has staged a long-awaited recovery over the past 12 months. It’s been great for long-suffering investors like myself.
However, Lloyds stock could push even higher in the coming years — that’s according to several analysts. And there’s one potentially overlooked reason for this.
Let’s take a closer look.
Unwinding the hedge
The UK’s major banks are poised to benefit from higher interest rates for years to come, thanks to a financial strategy called structural hedging.
The structural hedge, which banks use to protect their earnings from sudden interest rate changes, involves investing some assets in fixed income products.
Currently, most of these investments are in low-yielding products from when interest rates were lower.
However, as these investments mature, banks can reinvest at today’s higher rates. This gradually increases their income over time.
This process is expected to take several years, spreading the benefits over an extended period. Essentially, while this strategy has held back earnings in the short term, it’s set to become a significant advantage in the coming years.
For context, the yield on a five-year UK government bond is currently 70 basis points above Lloyds’ net interest margin.
What’s the impact?
According to some analysts, notably Jonathan Pierce at Deutsche Numis Research, the unwinding of the hedge — the movement of investments in lower rate fixed income to higher rate — could see profits at UK-focused FTSE 100 banks like Lloyds and NatWest rise by 80%.
In turn, this would mean that Lloyds is trading around four times future earnings — there isn’t a date for when this 80% increase could be achieved — but analysts have suggested it could take “a few years” for it to be realised.
So, what could this mean for investors?
Well, if earnings rise by 80%, Lloyds won’t be trading around 60p. It’d be trading much closer to £1.
What’s the maths behind this? Lloyds earned 7.5p per share in 2023, and an 80% increase would take us to 13.5p.
That’s a price-to-earnings ratio of just 7.4 times, assuming a share price of £1.
We can’t always trust forecasts
Pierce’s forecast that earnings could rise by 80% in the coming years is among the most optimistic that I’ve come across. And forecasts can be wrong.
It’s also worth remembering that banks have a very nuanced relationship with interest rates. For example, higher interest rates can result in higher impairment charges on bad debt.
The bottom line
While Pierce is bullish on Lloyds, several analysts have reverted to being ‘neutral’ on the bank in recent months.
And I think this points to the fact that there are still risks facing the UK economy, a war on our doorstep, and some uncertainty on interest rates. Lloyds really is a barometer for the UK economy.
For me, the crux of the issue lies with the valuation. The stock certainly isn’t expensive at nine times forward earnings. There’s also a margin of safety when using growth-adjusted metrics.
If my Lloyds holding wasn’t already quite sizeable, I’d consider investing more.
This post was originally published on Motley Fool
