The Lloyds (LSE:LLOY) share price has bounced up and down over the past two years as rising interest rates delivered strong returns but promised higher, and costly, default rates.
However, since February, we’ve seen the stock consistently push upwards. Earnings actually fell year-on-year but the stock has gained largely because of improving sentiment regarding the UK economy.
So should we be concerned about the red-hot Lloyds share price? Is it time for investors to consolidate their gains and should potential investors stay clear? I don’t think so. Here’s why.
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Things can only get better?
D:Ream’s ‘Things Can Only Get Better’ made headlines during the week as the song almost drowned out Rishi Sunak’s election date announcement. While I’m not convinced a new government has the capacity/fiscal headroom actually to make any difference to the UK’s economic trajectory, things (the economy) will likely get better anyway.
The UK’s economic forecast is relatively positive as we move towards in the medium term. And that’s incredibly important for banks because they are cyclical stocks. It’s even more important for Lloyds because it doesn’t have an investment arm, and around 60-70% of its loans are UK mortgages.
Falling interest rates
Coupled with an improving economic forecast is the expectation that interest rates will moderate. The current, higher interest rates are something of a risk for banks because sky-high repayments push customers closer to defaulting.
Interest rates are forecasted to settle somewhere between 2.5% and 3.5% in the medium term. This is the Goldilocks zone for banks because net interest income (NII) should be elevated and there are fewer concerns about defaults.
It’s important to note here that Lloyds is more interest rate sensitive than other banks because of the aforementioned reason — it doesn’t have an investment arm.
I think it’s fair to say however, that we’re not out of the woods yet. The latest inflation print came in above estimates, and if the Bank of England delays cutting interest rates, Lloyds shares would feel some pain. Some traders had been betting on a June rate cut. That’s looking increasingly unlikely.
It’s a marathon, not a sprint
Lloyds won’t deliver 17% share price growth every year — as it has over the past 12 months. However, if the UK’s economic woes improve and interest rates do fall as expected, we could be looking at something of a golden period for UK-focused banks.
Currently, Lloyds offers a 4.95% dividend yield. And it’s well covered by earnings. So that’s a great starting point if I’m looking to achieve double-digit total returns annually.
I’m being conservative here, but I reckon Lloyds shares could grow on average by around 5% annually over the medium term, taking the share price to 70p in five years. Given earnings projections, it would be trading around seven or eight times forecasted earnings.
So while there might be some more exciting investment opportunities out there, especially AI-related investments, I’m not selling my Lloyds stock. However, due to concentration risk, I’m not buying more.
