It's official, the UK is heading for a so-called hard Brexit, which is a headache for investors. If there's one thing the market doesn't like it's uncertainty. Unfortunately, over the next two year or so as the divorce is finalised, there's going to be plenty of uncertainty hanging over the UK's economy.
Some of London's banks have already said they're preparing to transfer jobs out of the UK as Brexit takes place and there will most likely be a period of re-adjustment for all of them as they adapt to new trade deals. So, how will a hard Brexit impact the UK's largest lender Lloyds Banking Group(LSE: LLOY)?
Since the financial crisis, Lloyds has been slimming down. After nearly a decade of selling non-core operations, the group has almost no overseas presence. This means it's less concerned than its City peers about what sort of trade deal emerges with the rest of Europe after Brexit.
As the UK's largest mortgage lender and one of the largest personal/business retail banks, Lloyds is almost entirely insulated from events overseas. That being said, the bank's fortunes are closely linked to the health of the UK economy, perhaps more so than most of its peers due to its lack of overseas diversification.
But even if Brexit destabilises the UK economy, Lloyds is well positioned to weather the storm. It has spent the last five years building its capital buffers and now has one of the most impressive tier 1 capital ratios in the eurozone. At the end of the third quarter, it reported a tier 1 capital ratio of 13.4%.
Soon after, stress tests from the ECB and BoE confirmed that Lloyds' capital buffers are now sufficient to weather any storm. Indeed, the ECB revealed Lloyds' tier 1 capital ratio fell to 10.1% under an EU-wide stress test of 51 banks. While under the BoE's test, Lloyds performed better than Barclays, RBS and Standard Chartered.
Set to plunge?
Ultimately, how shares in Lloyds react during the Brexit negotiations depends on the health of the UK economy. If economic growth remains robust, Lloyds' profits will continue to expand and investors will be happy to buy the shares. However, if slowing economic growth weighs on results, then shares in Lloyds could lurch lower.
Still, at the time of writing shares in Lloyds trade at a relatively low forward earnings multiple of 9.1, which implies investors aren't expecting much from it in the near term. Analysts have pencilled-in a decline in earnings per share of 17% for 2016, 4% for 2017 and 7% for 2018.
If Lloyds manages to beat these downbeat forecasts, then the shares could rally as investors re-rate the stock. But if the bank misses City expectations, there could be trouble.
The bottom line
All in all, shares in Lloyds may fall during the Brexit negotiations if the UK's economic growth starts to falter, although thanks to a robust capital position, the bank's long-term financial stability shouldn't be jeopardised and its 4.4% dividend yield looks safe.
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Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has recommended Barclays. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.