Why Barclays is now weakest big bank stock in Europe

Returns come back to bite

Barclays first quarter standout achievements include that it is consolidating its position as the most profitable bank of its size in Britain as UK returns inch further into double-digit territory (UK RoTE: up 150 basis points to 21.6%). These drove what would ordinarily have been lauded as more than satisfactory progress by group returns. Group RoTE hit 11% in Q1, using Barclay’s ‘average allocated tangible equity base approach’. That’s essentially on target, and just one point away from the old one that was abruptly dropped just before Jes Staley was announced as CEO.

Unfortunately, progress on profitability has been eclipsed as investors are instead continuing to accentuate the negatives on Friday. They’re reacting more to Barclays’ failure to reap the benefit of the mini bond-trading boom that buttressed quarterly revenues at most U.S. bulge-bracket banks. Markets income fell 4% at Barclays, particularly under the weight of a 14% decline in bond trading (usually about 15% of the bank’s revenue). Investors are cutting Barclays no slack for setting a tough comparable quarter to beat in Q1 2016.

Barclays regards the bulge bracket as its natural rivals in the states, and that is at least partly a projection fostered by CEO Staley, whose prior employer was JPMorgan. Softening trading is the first real disappointment on that front since Staley took over. Our perception is that investors had previously allowed the group a wider degree of tolerance than its closest peers. They overlooked a slower exit from unprofitable non-core activities and longer retention of risk-weighted assets relative to size on condition that Barclays’ riskier businesses would grow faster.

Waiting to get out of Africa

Investors’ reaction to its first quarter numbers suggests that Barclays’ non-core escape also needs to be faster and nimbler. True, the Africa situation is, for now, largely out of the group’s hands, as the protracted and low-visibility wait for regulatory approval goes on. The timeline in Africa has gone blurry though, and this adding to investors’ restiveness. Barclays agreed in February to pay BAGL £765m in total. It’s one of the terms set by South African Reserve Bank for the group to reduce its BAGL holding to below 50%. Barclays’ application to finalise the separation is currently stuck with SARB though. And the group has de-emphasised milestones towards approval. The Q1 statement only says Barclays is “on track to achieve regulatory deconsolidation, with further sell down subject to regulatory approval”.

An additional drag on the Africa business is political instability. Perhaps the intention, in itself, to dispose of the BAGL stake, is too. Impairment of the BAGL holding was “allocated to acquisition goodwill of £884m, primarily driven by the 17% decline in BAGL’s share price in the quarter”. A longer wait mean could Barclays eats into goodwill even further.

So, non-core losses are narrowing sharply and attributable profit rising—68 points narrower and 16.8% higher respectively, excluding a £74m valuation gain. But a lack of visibility in Africa and an apparent loss of trading edge are contributing to a further revaluation of CEO Staley’s divergent strategy vs. rivals. Reconsideration of the gambit, in turn, has caused Barclays shares to diverge from British rivals with a c.5% loss for the year so far against gains of 18% at RBS and 12% at Lloyds.

Whistleblown

Elsewhere, whilst we regard actions by Staley that led to board censure as a serious and ongoing regulatory matter, we struggle to see why the FCA/PRA will conclude that his “mistake” was so serious a misstep that he should step-down. However, rising wariness over the less risk-averse approach that Barclays’ CEO has become personally identified with is coinciding with concern over the whistleblower incident. Moderating investor perceptions also push continuing legacy issues closer to the forefront of the group’s investment case. The SFO probe of the Qatari cash call and the DOJ mortgage mis-selling case are now joined by the FCA/PRA probe.

Investors also cannot overlook the gap between Barclays’ Common Equity Tier One (CET1) ratio and a group of large London-listed peers (which averaged 13.8% at 2016-end). It is widening despite a 10 basis points rise to 12.5% at Barclays since December. In other words, Barclays isn’t becoming the type of bank regulators want it to be as fast as competitors; an additional potential drag on returns at the margin if the pace of Barclays’ CET1 improvement keeps lagging. At the same time, group cost: income ratio still trails rivals at 62% even after the sharp 14 percentage point improvement in the year to Q1. An additional calculation for investors as peak Brexit approaches is how close British banks are to optimum performance.

Staley’s strategy is therefore facing its toughest test, even assuming SARB concludes deliberations much sooner than the group’s 2-3 year sell-down target. Barclays stock will continue underperforming UK and European rivals this year if the CEO isn’t vindicated soon—once again.