Lloyds(LSE: LLOY) reported a strong financial performance in its Q3 results last month, upped its financial targets for the full year and said it's on track to deliver its longer-term guidance. However, for a number of reasons, I believe the outlook for it meeting investors' current expectations -- particularly on dividends -- is deteriorating and that the risk of a severe downturn is rising.
Red flag alert on business distress
Insolvency specialist Begbies Traynor released its latest Red Flag Alert Report earlier this month and it makes for ominous reading. It revealed that nearly half a million UK businesses ended Q3 in a state of "significant" financial distress, with rises across "every sector and region" such that over the last 12 months the number has reached "unprecedented levels."
With many companies having been kept alive since the financial crisis only by the life-support machine of low interest rates, insolvencies look set to increase markedly as the interest rate cycle turns. Bad loans at Lloyds rose by almost a third in Q3 to £270m and while the bank said this was due to "a single large corporate impairment," the Begbies report suggests there could be a lot more to come.
Biggest consumer credit bubble in history
Perhaps an even bigger concern is the UK's massive consumer debt bubble, with personal debt having inflated to unprecedented levels. While Lloyds said in its Q3 report that "overall credit performance in the mortgage book remains stable," many stretched consumers on variable rate mortgages have said that even a modest rise in payments would cause them financial hardship.
Meanwhile, one of the biggest areas contributing to consumers borrowing at a rate almost five times faster than the growth in their earnings has been car finance. Lloyds is the bank with far and away the biggest exposure to car loans. While Q3 saw a "stable credit performance" in the business and Lloyds continuing to increase lending, this really does look to me like a bubble set to pop.
Finally, there are indications that the consumer credit bubble has become so inflated that an increasing number of people are in the unsustainable position of relying on credit cards to pay for essentials. Lloyds has recently increased its exposure to unsecured consumer credit with the acquisition of credit card business MBNA. Again, while the bank reported no credit performance issues in its cards book in Q3, I think it unlikely this will be maintained.
Adverse shift in risk/reward balance
Previously, I liked Lloyds' potential, particularly to deliver dividends from its target CET1 ratio of 13%. However, the bank disclosed in its Q3 results that it's seeing "upward pressure" on this capital requirement. I see credible arguments from some City analysts that the hurdle rate may now have to move towards 14.5%, with severe implications for future dividends -- namely, a more modest yield and lower growth than many investors currently envisage.
Against this potential for a lower reward, there is what I can only see as an increased risk of severe downside, due to the unprecedented number of businesses now experiencing significant financial distress and the biggest consumer credit bubble in the UK's history. As such, I feel the risk/reward balance has shifted adversely with Lloyds and I see it as a stock to avoid.
G A Chester has no position in any of the shares mentioned. The Motley Fool UK has recommended Lloyds Banking Group. 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.