European banks have outperformed the tech-focused Nasdaq in 2024, and the Lloyds (LSE:LLOY) share price is a testament to that.
Lloyds stock is up 15.6% since the beginning of the year. Interestingly, it lags NatWest and Barclays which have faired even better.
So where will Lloyds go from here?
Things will probably get better
As a shareholder in Lloyds, the long-run performance has been disappointing. However, the group’s been operating in fairly unique circumstances, and banks are cyclical stocks.
Brexit, the pandemic, a weak economy, and monetary tightening (rising interest rates) are indicative of this turmoil. This has been compounded by political upheaval as well as secular trends surrounding productivity and investment in the UK.
Lloyds has been more exposed to these pressures than its peers because it only operates in the UK. Around 68% of loans are UK mortgages.
Thankfully, the broad economic picture is expected to improve. Interest rates are set to fall towards the Goldilocks zone — that’s somewhere between 2.5% and 3.5% — over the next three to five years. Capital Economics suggests the base rate will hit 3% by the end of 2025.
Moreover, economic growth is expected to normalise. Banks tend to be a barometer for the health of an economy, so this should be reflected in the stock price moving forward.
Interest rate sensitivity
Lloyds is among the most interest rate-sensitive of UK banks. The reason for this is that it doesn’t have an investment arm. Almost all of Lloyds’ operations are sensitive to interest rate fluctuations.
For context, a whopping 75% of Lloyds’ £4.25bn revenue last quarter came from net interest income (NII). So with interest rates set to fall, NII on its £450bn loan book will also decrease.
However, falling interest rates aren’t a headwind. One positive is that customer defaults become less of a concern as pressure on borrowers falls. In recent years, Lloyds’ worst quarter for credit impairments was Q3 2022 — £668m.
Moreover, banks operate structural hedges which allow them to reduce sensitivity to interest rates. Even in the face of moderate interest rate cuts, Lloyds can look to expand margins on its £245bn structural hedge through swaps and other means.
The bottom line
Overall, I believe Lloyds will be a net beneficiary of falling interest rates. I think the market agrees with me. Moderating interest rates will contribute to a stronger economy and reduce default risk.
But where will this take the share price? Well, the consensus of all analysts covering the stock is that fair value is currently 60p — that’s a 9% premium to the current share price.
In six months’ time, and assuming interest rates do fall, I’d expect the target price to push higher still, and the actual share price to follow. Sadly, UK stocks tend to trade at a discount to the target price.
Everything being equal, which it rarely is, I’d hope to see Lloyds’ shares trading a little closer to 60p than they are today.
