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Investors should buy Lloyds shares as the interest rate outlook improves

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Lloyds (LSE:LLOY) shares fell this week after results disappointed in February. But, for me, this is one of the most attractive companies on the FTSE 100, and recent commentaries on interest rates have reinforced this.

So let’s take a closer look at why I think investors should buy Lloyds shares, and why I’m buying more.

Results didn’t disappoint me

In the 2022 earnings report, I was a little shocked by the size of the bank‘s impairment charges — £1.5bn — but, broadly, I was happy to see profit remain flat.

In 2022, net income rose 14% to £18bn, driven by higher rates. The net interest margin (NIM), essentially the difference between lending and saving rates, rose 40 basis points, ending the year at 2.94%.

In truth, considering the concerns about the health of UK economy, it didn’t disappoint me.

Interest rates drive revenue

Lloyds is now targeting a NIM of more than 3.05% for 2023. The bank is more interest rate sensitive than its peers, due to its funding composition and the lack of an investment arm. It’s also much more focused on the UK — 100% of sales take place in Britain and the majority of income comes from mortgages.

Higher rates also mean that banks can earn more interest on the Bank of England (BoE) deposits. It had £145.9bn of eligible assets with £78.3bn held as central bank reserves at the end of the second quarter last year.

Analysts suggest each 25 basis point hike from the BoE will add close to £200m in income solely from holdings with the central bank.

However, it worth highlighting that demand for loans goes down the higher interest rates get. So investors should be pleased to hear BoE governor Andrew Bailey saying that more rate rises are not inevitable, despite very sticky inflation.

Central banks around the world are trying to carefully reduce economic activity in order to bring down inflation without causing untold damage to the economy. Essentially, there isn’t enough strength in the UK economy to push rates much higher.

What we may be looking at in the UK is a lower terminal rate, but for a longer period of time as inflation is stickier than expected. I believe this would benefit Lloyds and its peers.

However, I am a little concerned — as is the market — that China’s rebound could engender even more inflation globally.

A new Brexit deal

The UK economy is estimated to be 5.5% smaller than it would have been had it stayed in the EU, according to a study by the Centre for European Reform. And since the Brexit vote, foreign direct investment and business activity in the UK have fallen.

This has impacted Lloyds more than other banks, and notably its commercial loans business.

However, we now have a new Brexit deal, and should it gain political support within the UK — which I believe it will — billions of pound of foreign investment could be unleashed. Bloomberg has been reporting that dozens of US businesses are lining up to invest in Northern Ireland.

In theory, this should be positive for Lloyds’ commercial loans business. Hopefully, the UK’s decline has reached a turning point.

The post Investors should buy Lloyds shares as the interest rate outlook improves appeared first on The Motley Fool UK.

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James Fox has positions in Lloyds Banking Group Plc. The Motley Fool UK has recommended Lloyds Banking Group Plc. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

Motley Fool UK 2023