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​​UK bank shares: who will outperform when Brexit is resolved?​​

UK-listed banks have diverged depending on their international focus. With the domestic banks underperforming on the FTSE 100, the outcome of Brexit should guide which banks will outperform.

Brexit Source: Bloomberg

UK financial sector on rollercoaster ride

The financial sector has seen a somewhat topsy-turvy time since the 2016 referendum, with banks having seen both losses and gains throughout the course of the past three years. The chart below highlights that journey, with gains throughout the 12-month post-referendum being followed by a period of consolidation and subsequent decline.

The chart also signals a clear divide between the domestically-focused banks and Asia/globally-focused banks. This distinction is something that must be considered when trading the UK-listed banks, with the economic impact of Brexit likely to be diluted for those firms whose earnings are more global.

UK banks chart

Banking sector trails wider market

Consolidating those two groups, it is interesting to see that the wider market has largely outperformed the domestically-focused banking sector which has particularly lagged since the second half (H2) of 2017. The chart also includes business optimism, which is a useful proxy and leading indicator for the strength of the UK economy and investment decisions.

That indicator highlights that as we got closer to the perceived end to the Brexit negotiations, we have seen business confidence and subsequently growth take a dive. As such, what we can glean from this chart is that the decline in the UK economy has hit the domestically focused banks harder than those within. That is interesting from a post-Brexit trading perspective as it would guide us in knowing where the industry could move in each eventual outcome.

UK banks vs FTSE chart

UK banks and interest rates

The UK banks are sensitive to interest rate changes at the Bank of England (BoE), with higher rates providing a more beneficial environment for lenders. Higher rates mean higher margins for banks when it comes to lending out money to individuals and businesses. That is going to be a consideration when it comes to Brexit, for each outcome is likely to bring a very different outlook from the BoE.

How to trade UK banks in a no-deal Brexit

A no-deal Brexit would be expected to hit the pound hard, driving outperformance for those firms that earn abroad vs those domestically-focused companies. Thus, we would expect to see the FTSE 100 outperform the FTSE 250.

From a banking perspective, an economic decline coupled with a weaker pound would mean that the likes of Lloyds, Barclays, and Royal Bank of Scotland (RBS) suffer a greater decline than both their Asia-focused counterparts, and the wider FTSE 100 market. From a monetary policy standpoint, we would likely see a rate cut from the BoE in the aftermath of such a no-deal scenario. That once again shifts the pressure on banks, denting margins and profitability.

How to trade UK banks in a soft Brexit

A soft Brexit would serve to allay many of the fears associated with a no-deal Brexit. That boost in sentiment would likely shift the dial for the pound, yet there would still be a significant amount of uncertainty over how businesses will emerge from this new dynamic.

That initial jump in the pound would serve to hit those firms that heavily rely on foreign earnings, denting the likes of HSBC and Standard Chartered. However, from an economic standpoint, much of the impact will depend on exactly what deal is reached between the two sides.

Thus in this scenario, traders will be following economic developments closely, with signs of strength expected to benefit domestically focused banks in particular. However, should the economy fail to adapt easily to the new norm, any economic slide would likely hurt domestically-focused banks in comparison to those Asia-focused firms.

How to trade UK banks in the event Brexit doesn’t go ahead

A reversal the original referendum would provide a major boost to the wider economy, ramping up gains for the pound too. That sterling appreciation would hold back gains for internationally focused firms, lessening upside for the FTSE 100.

However, as we have seen, the economic outlook and performance would disproportionately benefit domestically-focused banks over the wider market. Thus, it makes sense to look for longs at the likes of RBS, Lloyds, and Barclays as the wider economic recovery drives greater investment and spending. Interest rates would also likely start to rise as a result, raising the margins for UK lenders. Sterling appreciation could lessen inflation to dampen those rate hike expectations, yet that could take some time to show through.

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