Is Lloyds among the banks to buy in 2018?

Through the fog of Brexit and uncertain UK outlook, some much-needed cheer emerged for our army of Lloyds Banking Group investors today.

The new year fillip came courtesy of UBS, whose European banking analysts think there's a potential 26% upside in the Lloyds share price, fuelled by the prospect of a dividend yield of over 7%.

This positive assessment places Lloyds among UBS's seven European banking top picks, which is pretty significant given that the economic outlook is much stronger for peers operating in continental Europe.

While UBS expects Lloyds earnings per share (EPS) growth to be broadly flat up until 2019, it is encouraged by the potential for strong capital generation to finance that divi yield, which stood at 4.5% in 2016.

In contrast to Lloyds, UBS is less keen on HSBC and Standard Chartered after the Asia-focused pair were named among UBS's five least-favoured bank stocks.

UBS is also wary about the European banking sector in general, even though economic prospects appear to be improving. It warns that the next six months carry the potential for earnings downgrades driven by risks around net income growth, cost inflation and the continued threat posed by European regulators.

The note said: "Banks may be relatively cheap to other cyclical sectors and to the market but on a standalone basis we see them as at broadly fair value."

This means investors need to be highly selective, which is why UBS favours cheaper banks with strong levels of free cashflow generation as a buffer against regulatory uncertainty, cost inflation and sluggish revenues.

This applies to Lloyds, which features alongside Credit Suisse, Danske Bank, ING, Santander, SocGen and UBI Banca on the UBS list of most favoured stocks.

In its section on Lloyds, headlined "Safer than you think", UBS says that net interest income generation at the bank is more sustainable than the market has been giving it credit for. In particular, there's room for re-pricing of deposits and growth in residential mortgages, as well as further cost savings.

The bank adds: "If Lloyds proves capable of continuing to outperform peers such as Barclays in unsecured loan losses, defend interest margins and grow the balance sheet, we would expect the share to re-rate."

On the downside, UBS warns that its dividend forecasts are based on expectations that capital requirements do not increase materially beyond previous requirements.

Lloyds shares were 1% higher today, although at 68.1p remain stuck in the range of between 62p and 72p seen over the past year. That has fuelled disappointment among investors after the bank was the most-bought stock on the interactive investor platform in 2017. They will be encouraged that UBS thinks the stock can reach 85p.

Looking at HSBC, today's note warns that the market's current valuation allows little-to-no discount for the risk that HSBC fails to deliver margin expansion and strong cost control. "Disappointment in either area would be a significant negative for the share, we think."

UBS has a target price of 725p, with forecast dividend yield of 5%.

The bank's analysts are also 'neutral' on Standard Chartered amid concerns about the achievement of a promised expansion in its net interest margin (NIM).

They said: "The StanChart turnaround proceeded according to plan in 2017 assisted by management action in 2016 and a benign credit environment.

"The ask in 2018 and beyond, however, is far more of a stretch, in our view, demanding volume growth and margin expansion, an absolute decline in costs and another year of modest loan losses."

UBS is targeting a share price of 760p and 1.4% dividend yield.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.