• As profits have risen and dividend payments resumed, UK banks have started to return to favour - though we remain in the more cautious camp.
• Other financial companies are more attractive, with less leverage and core strengths to protect margins.
• Given that inflation may now have peaked, the chances of significant, sustained interest rate rises coming to the aid of bank investors looks unlikely.

Profits and margins are up, impairment losses down and dividends are coming back: almost 10 years on from the global financial crisis, UK bank stocks have been tentatively returning to favour. With balance sheets largely repaired and excess capital being paid out to shareholders, a growing band of investors are deciding to give banks a second look.

However, our long-standing negative view on most UK banks remains unchanged. Indeed, it has been reinforced by the superficially positive news that has been emanating from the UK banking sector. In our view, while UK banks have somewhat healed, they are currently overearning and with impairments expected to rise from multi decade low levels, we feel that profitability could fall from current levels and therefore remain negative on the sector.

Our investment philosophy focuses on buying high-quality companies at attractive valuations. In our opinion there are better opportunities to be found elsewhere in the financial sector. Opportunities that offer the potential for solid long-term, risk-adjusted returns.

POSITIVE ON INSURANCE

We are overweight insurance, for example, with a big active position in Prudential.* At 4%, the global insurer is one of the top holdings in our core Threadneedle UK equity strategy. Prudential is a market leader in growing Asian markets, giving it an edge on its rivals, but the value of its business model isn't reflected in the price.

We are also overweight in 'other financials', a broad church that includes asset managers and real estate investment trusts (REITs).

London Stock Exchange (LSE)* has been our biggest active position in our core Threadneedle UK equity strategy for some time. LSE benefits from high cash flow and high margins and we support the chief executive's vision to create a global markets infrastructure company.

In the REITs sector, we have owned Derwent London* for a long time, and also bought Land Securities a year ago. Our view was that, following the Brexit vote, property prices would not correct to anything like the degree that bears were suggesting (and that the share prices of REITs were implying).

We have been proved partly right; property has held up well due to the influx of international investors and the fact that rent rolls are stable. However, this more bullish-than-expected outcome has yet to be reflected in the price of REITs.

PEAK MARGINS

UK bank stocks also suffered in the weeks after Britain voted to leave the EU, though in their case the pain began long before Brexit became a reality. Banks around the world have spent much of the past decade trying to restore credibility following the trauma of the financial crisis - with some success.

In a tougher regulatory environment, businesses have been restructured and balance sheets rebuilt. Lloyds Banking Group and Royal Bank of Scotland (RBS),* both of which had to be bailed out by the UK government, are currently delivering high margins with impairment losses well below multi-cycle lows.

Yet, this doesn't give us confidence. Margins, having peaked, look likely to trend down. Meanwhile, impairment losses can only trend up from such a low base. We are not arguing that we are about to witness another banking crisis. Simply that the earnings on which banks are valued today feel vulnerable.

The act of accurately valuing banks is already made difficult by the way that capital is calculated and quantified in the UK. The system gives a false picture of the health of banks as it treats mortgages as if they are of little risk.

Investing in banks is inherently risky because they are so leveraged. In our view, in the event of a housing slowdown and house price correction there would not be enough bank capital in the system to absorb mortgage losses.

This isn't a macroeconomic view; we are not saying that the UK housing market is going to collapse. However, the risk of mortgage impairments rising, and its failure to be reflected in capital calculations, is one that investors need to recognise.

LINGERING COSTS

So is the fact that, even though capital reserves have improved, banks have not been able to retain earnings as they should because of huge restructuring charges and compensation payments for past scandals.

Lloyds, now fully back in private ownership, has had to earmark more than £18 billion for PPI compensation, setting aside another £350 million in the first quarter of this year [2017].¹ RBS, still part-owned by the government, was recently ordered to pay $5.5 billion to US regulators following a probe into the sale of mortgage-backed securities.² Barclays is the subject of a criminal investigation by the UK's Serious Fraud Office.³

We worry that banks are not being run with long-term growth in mind. HSBC's investors are waiting for a new chief executive to be appointed given that Stuart Gulliver is likely to step down next year. If HSBC wants to be a growth company it would need to address how much capital needs to be reinvested as opposed to distributed.

Standard Chartered* is one of the few UK-listed banks where we hold an active position. We took part in the last capital raising at close to half book value. The bank has been a restructuring story, provides access to Asian growth markets and has built a strong capital position.

UK banks might possibly benefit from higher interest rates which could bolster their margins, but I fear that the economy does not look ready for an interest rate rise. The UK will probably be the last major economy to shift from quantitative easing to quantitative tightening, behind the US and the newly-emboldened eurozone.

The risk of an inflation shock could force the Bank of England to tighten earlier than it would prefer. However, our view is that such a scenario is unlikely and unwelcome. We believe that the pick-up in prices seen over the past year is primarily a one-off adjustment to weak sterling, and that inflation may well be in the process of peaking. We expect the Bank of England to resist calls to tighten early.

Our view is that impairment losses are likely to accelerate before any support for the banks comes from rising interest rates. With rates staying lower for longer, banks' net interest margins and earnings are likely to come under considerable pressure.

Our investment philosophy focuses on buying high-quality companies at attractive valuations. In our opinion there are better opportunities to be found elsewhere in the financial sector.

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* The mention of any specific shares should not be taken as a recommendation to deal.

¹ Financial Times: Lloyds Bank profits miss estimates after further rise in PPI costs, 27 July 2017.
² Financial Times: RBS to pay $5.5bn to US authorities over mortgage-backed securities probe, 12 July 2017.
³ Financial Times: FDIC sues Barclays, RBS and other banks over Libor, 17 August 2017.