LYG - Lloyds Banking Group: Hold For Now

Summary

• Lloyds Banking Group has a low market valuation, good dividend yield, and has upgraded its outlook for margins recently. Is its price drop a reason to buy?
• Its stronger price correlation with the UK economy than its own earnings suggests further potential weakening is possible, as growth is expected to slow significantly.
• Despite a largely dependable dividend history, save the pandemic period, Lloyds Banking Group's weak price indicates it's best to hold the stock for now.

On paper, Lloyds Banking Group plc ( LYG ) looks good. Its price-to-earnings (P/E) ratio at 6.4x is much less than that for the sector, even though recently upgraded its outlook. Its dividend yield at 5.3% isn't bad at all. So far, its key market, the UK, hasn't succumbed to a recession which could potentially hold it in better stead than U.S.-focused banking entities.

Yet, its price refuses to rise. On the contrary, it has fallen by 24% in the past year at the time of writing. Admittedly, this hasn't been a good year for stocks, but it's still hard to overlook that LYG's price performance has been worse than most of its peers. This article analyses it in the context of the macroeconomy and its own historical price and dividend performance as well as its market valuations. It concludes that it's best to hold off from any actions on the stock for now.

Correlation between Lloyds' Price and UK GDP growth

To start with, LYG's price correlation is analyzed with the UK's GDP growth, since the geography accounts for much of its business. This is distinct from other publicly listed banks like HSBC and Barclays, which have a presence in the UK but also have significant interests in Asia and the U.S., respectively. To analyze the correlation between LYG and the economy, both half-year and full-year net income growth rates were considered in relation to GDP growth rates for the UK. For numbers starting in 2017, the correlation coefficient is at 0.75, indicating a positive correlation.

While as of the last quarter, UK's economy is indeed weak , so far it has warded off a recession, which is something of a positive. However, it's expected to slow down next year. In 2023, its forecast to grow at just 0.5% , down from an expected 3.2% in 2022. So far, as LYG's price correlates with GDP growth, it then suggests a likely come-off.

LYG trends downwards

This is disappointing, considering the already sluggish LYG price trend. Over the past decade, Lloyds Banking Group has broadly been trending downwards. To be fair, this period includes both the Brexit and pandemic periods, both of which took a toll on it. That said, it was declining even during the earlier part of the decade. The key takeaway here is that LYG hasn't been a good investment for capital gains over time, even though it has seen some increases. In fact, it has fallen by 8% on average each year over the last 10 years and has seen around a total 60% decline.

Promising dividends

Lloyds' dividends, though, are still attractive, particularly since it has paid them consistently since 2014, even though there have been pandemic-related fluctuations that saw a cancellation of its final dividend for 2019 and interim dividend for 2020. However, for the three years before the pandemic, dividends were relatively elevated per ADR . Further, they have been inching up since 2021 and are expected to continue doing so in 2022 as well as per analysts' estimates .

Even more encouraging is the rise in the bank's dividend cover. For 2022, earnings and dividend forecasts project it to be at 4.6x, after already coming in strong at 4.3x for the year before. In fact, even though the actual dividend levels have been low in the past three years, the cover is far healthier than it was during the 2015-18 period. Both LYG's recently rising dividends and its improving dividend cover bode well for passive income from it in the future.

Do attractive market valuations matter?

Further, its market valuations also look attractive. Right now, its current price-to-earnings is at 6.8x compared to the sector median of 10.2x and its price-to-book ratio is at 0.57x compared to 1.17x for the sector. Technically, this could reflect some upside to it, especially going by its improved outlook for net interest margins .

However, this matters to the LYG price only if its performance and its outlook get reflected in it. This doesn't seem to be the case so far this year. Considering, however, that this has been a bad time for equities, a longer-term correlation between annual net interest income, a crucial part of its total income, and the LYG price, both in YoY terms, was done. It reveals that a change in price can react with a one-period lag, with a correlation coefficient of 0.6.

This is not as strong a correlation as that with GDP growth, but it isn't low enough to be ignored, either. Taking both into account, however, suggests that if GDP growth declines further, as is expected, it could dominate share price movements, at least for now. Also, a poor economy is anyway bad for loan growth, which could affect the bank's net interest income soon enough anyway. Whichever way we look at it, it's hard to get bullish on LYG right now.

Conclusion

As far as outcomes for LYG can be closely linked to the macro economy, however, at this time it's also essential to look at the other side. The UK government's latest policies aim at providing a fair bit of stimulus to the economy. These include tax cuts and projections for a 2.5% trend growth rate. Since Lloyds Bank is focused on core banking, it can benefit in particular in a thriving economic environment. Further, this analysis is by no means exhaustive or has the capacity to be so, and there are a number of other factors that can impact LYG, including buybacks for instance.

However, that doesn't take away from the fact that we have a scenario of weak share price which could well continue going by its past price trends and the big picture outlook. Even with a dividend payout, it's possible to end up with net-negative returns on this investment. It's best to hold the stock if it's already in the portfolio or hold off from buying it for the time being altogether.

For further details see: