Lloyds (LSE: LLOY) has been a pretty poor investment to own over the past few years. After the financial crisis, the lender struggled to rebuild. But after around a decade, it was finally standing on its own two feet.
The group had restructured its balance sheet, slashed costs, and streamlined operating processes. It had also acquired credit card business MBNA and launched a wealth management arm to help diversify.
Despite these efforts, the bank’s been hamstrung by low-interest rates.
Lloyds share price headwinds
The bank’s basic business model’s relatively straightforward. These institutions take money from clients or depositors, pay them a rate of interest, and then loan the money out at a higher interest rate. The gap between the interest rate paid to depositors and received from borrowers is known as the interest rate spread.
Banks only have a limited level of flexibility when it comes to setting interest rates. The Bank of England sets the interest rate for the whole country, and lenders like Lloyds have to base their rates on this benchmark.
As interest rates have languished, the Lloyds share price has struggled to move higher. The group’s interest rate spread has remained relatively constant over the past decade, but its balance sheet has shrunk as the enterprise has exited non-core operations. As such, the company’s earning the same return but on a lower level of assets.
If interest rates rise, Lloyds’ interest rate spread should increase. This should help boost profit margins, reversing a decade-long trend.
The market estimates that the Bank of England will begin to increase interest rates next year. Only a modest hike is expected, but it is something. This will allow Lloyds to increase the rate it charges borrowers and hopefully improve its profit margins.
If the bank can improve its profit margins, the Lloyds share price should begin to reflect its improving outlook.
Risks ahead
Unfortunately, this isn’t guaranteed. The UK banking market’s highly competitive. Even if the Bank of England hikes interest rates, intense competition in the market may prevent lenders from increasing costs for borrowers. This could hold back the performance of the equity.
Other challenges the group has faced since the financial crisis include higher costs and increased regulation. Neither of these headwinds will reverse if interest rates start to rise. Therefore, the lender’s profit margins may remain under pressure.
Despite these risks, I think the outlook for the Lloyds share price is improving. The economic fallout of the coronavirus crisis was nowhere near as bad as some analysts were expecting. As a result, the bank has exited the crisis in a relatively strong position. This should enable the enterprise to capitalise on the economic recovery this year and next.
With this being the case, I’d buy the stock for my portfolio as an economic recovery play.
