UK Banks: Death by a thousand cuts
As the UK consumer is about to be hit by a triumvirate of higher food, energy and mortgages costs, a story which will play out over the next seven quarters, RBC Capital Markets expects a recession and a softening housing market. As a result, it increases its 2023 CoR assumptions for UK retail banks by 8bps, which is 12bps above consensus, and prefers specialty lenders over the large retail banks.
Higher mortgage rates will further squeeze the consumer
Although rates remain low historically, monthly payment on fixed rate mortgages is increasing and is likely to go higher, driven by a steepening of the forward interest rate curve, with rates now expected to reach 3.0% by y/e 2023, RBC notes. As the UK consumer is already being hit with higher food and energy prices, the squeeze will likely be felt even more when their mortgages come up for renewal. This will be especially difficult for first time buyers, whose mortgage payments already make up c.30% of take-home pay. Although household debt to disposable income is well below the 2008-2009 financial crisis peak, it is already above average historical levels (130% vs 120%).
The majority of the impact will not be felt for seven quarters
With c.80% of mortgages being fixed rate (2yr c.25%; 5yr c.45%, others c.10%), and c.20% of the mortgages in the UK being variable rate (inc SVR), the pain will not be felt by everyone at once. RBC has modelled the roll off profile of UK mortgages, by looking at mortgage flows by product over the last ten years. The conclusion is that it will take seven quarters for the majority (>50%) of mortgage customers to feel the impact from recent rate rises, with the biggest step up in rates impacting customers in Q3'23. The next question is how able is the consumer to absorb these higher costs? UK consumers may have built up a nest egg of deposits since the beginning of 2020, this buffer is not evenly spread across households, with middle/high income households & retirees saving more than lower income households.
A recession and a softening housing market
RBC’s base case is a softening of the housing market, but not a big correction since there is still a structural shortage of homes for sale in the UK and the government seems willing to step in to support the housing market. Although coverage levels are elevated vs pre Covid-19 levels, RBC believes a recession combined with a squeezed consumer will lead to higher cost of risk in the medium term. As a result, RBC has raised its 2023 CoR expectations for UK retail banks by 8bps to 36bps, above consensus expectations and sees more risk for those banks exposed to the South, higher LTV & variable rate mortgages.
A preference for specialty lenders
RBC worries about first time buyer volumes (c.20% of total volumes) since it’s never been less affordable to own a home, especially in London, the South and East of England, while the North and the Midlands are more affordable. RBC expects this picture will become more distorted over time as travel infrastructure improves and as the shift to work from home means that salaries will become more fungible. Overall, RBC thinks specialty lenders will fare better in the UK banking sector, offering c.30% upside vs. the large retail banks where it only sees c.10% upside.
