Feature Stories | Nov 15 2017
Take out weak market income and the major banks showed solid underlying trends in their results. But for how long?
– Weak results of no concern
– Underlying trends positive
– Tailwinds to continue…
– …before easing next year
By Greg Peel
On face value, the major banks’ recent earnings results were weak, and below expectation. ANZ Bank ((ANZ)), National Bank ((NAB)) and Westpac ((WBC)) have all now posted second half FY17 results and Commonwealth Bank ((CBA)) a first quarter FY18 update.
Over the period, the banks all suffered a drag from the government’s bank levy and from fines and regulatory compliance costs emanating from their various indiscretions. But the biggest drag on earnings was market income.
Market income refers to profits made by the banks’ proprietary financial market trading and broking activities. For these divisions to be profitable, market volatility is required to provide for both trading range opportunities and client interest. What did we see over the period in question? A stock market stuck in the same range for months, with the VIX volatility measure at an historical low, and the RBA’s cash rate unchanged, leading to little volatility in interest rates.
It was a tough period to try and make money in. When under different circumstances the banks exceed forecasts due to elevated market income, analysts label such profits as “low quality” for the simple reason market volatility is itself volatile. Banks can make lots of money in one period and not so in the next, while having little control on what that outcome might be.
Thus if market trading profits are of low quality, poor market trading performances are equally written off by analysts as not something to be concerned about. And that was the case with regard the recent round of results.
Decent Underlying Performance
Ignoring market income, analysts saw a pretty good underlying result from the majors over the period. Revenue growth was solid, reflecting mortgage repricing. Asset quality continued to improve, implying yet another earnings boost from lower bad & doubtful debts (BDD).
Underlying net interest margins improved, despite the drag from the levy and regulatory costs. Aside from the banks all increasing rates on investor mortgages and interest-only mortgages, on the other side of the equation, wholesale funding costs fell. Competition among the banks on deposit rates eased.
I have noted in these bank reports for some time now that analysts have long assumed BDDs would soon rise off their low base, largely because history suggests such cycles are inevitable. But all too often in the past bank analysts have been caught in the headlights of history without paying sufficient attention to the reality of the present.
We recall the initial response from analysts when the Global Credit Crunch began morphing into the Global Financial Crisis was to recommend buying the banks, because historically they are defensive. This blind recommendation ignored the fact the crisis at hand was in the global banking industry. And we know what happened next.
It now also seems analysts are easing up on their knee-jerk assumptions BDDs must, by default, rise, simply because they are never this low. Why would they rise? Interest rates have never been this low, the Australian economy is looking healthy and unemployment is low with jobs growth to the upside.
Sure, there was a scare last year over certain “pockets of weakness” – a run of big single name defaults (eg Dick Smith), problems in Western Australia as a result of the mining investment boom ending, and problems in New Zealand as milk prices crashed. But the single name run turned out to be a blip, and the other “pockets” have seen weakness easing.
As Deutsche Bank puts it, “There was little to suggest [in this result season] a material deterioration in credit quality is imminent, with no new problem areas”. So notwithstanding any left of field shocks, we can probably now put analysts’ longstanding BDD warnings to bed.
We have also now eased off on fears over bank capital positions, which so dominated the past couple of years as APRA waited interminably for new Basel IV international guidelines that never came, before spending another lifetime finally deciding what the earlier throwaway line of “unquestionably strong” actually meant in real numbers. It meant 10.5%.
Analysts all agreed at the time achieving a tier one capital ratio of 10.5% by the 2020 deadline would be a stroll in the park for the majors. As at this result season, ANZ and Westpac are already over the line, with ANZ in particular benefitting from asset divestments. NAB is dragging the chain on 10.1% but should catch up ahead of time. CBA was looking comfortably on track in the middle, but we’re yet to find out just what extent of fines the bank is in for.
The bottom line is that bank investors no longer have to fear possible capital raisings and/or dividend slashes in order for the banks to meet stricter capital requirements.
All looks rosy in bank land. Or does it? What can investors now look forward to?
Things are looking a little rosier on the bank market income side as we move into FY18 (further into FY18 for CBA). The local stock market has at least broken out of its range. But FY18 will see bank earnings being handicapped by a full year of the government’s bank levy and as noted, there remains an unresolved issue of fines.
On the positive side, mortgage repricing benefits will continue to flow through. But APRA’s crackdown on interest-only loans, and subsequent hikes to banks’ variable IO rates, has prompted a flood of property investors switching to standard principal & interest loans at lower rates.
The banks should continue to enjoy an earnings boost for another six months or so. However, the flipside is additional APRA restrictions regarding the ratio of risk-weighted assets held in bank portfolios, which in short means the banks have to cut the number of riskier loans on their books (investor, interest-only) as a ratio of all loans. Repricing those mortgages goes some way to achieving such a reduction, as existing investors switch to P&I and potential new investors are put off, but this also ultimately implies lower loan book growth.
Analysts agree that the impact of tighter APRA restrictions is still an ongoing story in the sector rather than a one-off event. The benefits of repricing will continue to provide a tailwind. But eventually the number of investors still looking to get into the property market will ease, offsetting those repricing benefits.
There will be a point at which any further repricing will lead to a fall-off in demand to the extent that bank earnings reduce, not rise. And that’s in isolation, before we begin to even talk about signs the Australian housing boom is now cooling.
Morgan Stanley, for one, suggests bank margins are currently in a sweet spot that won’t last as far as the second half of FY18. The broker expects margins to fall back again later next year as repricing comes to an end, more borrowers switch to P&I, the banks start to offer discounted mortgage rates to attract new borrowers, and lower household savings means competition also heats up again for deposits.
Morgan Stanley is not alone. One need only make note of the various brokers’ result season report headlines. “Has retail banking seen its best days?” asks Citi. “Environment challenging,” suggests Deutsche Bank. “Tapped out on revenue growth,” says Credit Suisse.
It has nevertheless been a while now that bank analysts have warned of subdued earnings growth ahead. The question is as to whether or not such a view is reflected in bank share prices.
One of the enduring bull arguments for the banks, notes Goldman Sachs, that bank PEs are trading at a -30% discount to non-bank industrial PEs compared to a 17-year average of -15%. But as Goldman notes, the banks are expected to deliver less earnings growth and return on equity compared to non-bank industrials than has been the case on average since 2000.
Thus, suggest the analysts, unless one believes the risk inherent in the Australian banking system is materially less today than has been the case since 2000, the banks appear to be trading at relative fair value.
Ord Minnett nevertheless cites such a discount, alongside a 6% forecast dividend yield, as providing for a “reasonable” 9% forecast return over the next 12 months.
Macquarie suggests the banks are “priced to be boring,” but despite a low growth environment they should continue to generate surplus capital and offer capital management opportunities. Macquarie too cites the relative PE discount as supporting what the analysts see as a subdued growth environment already priced in.
Deutsche Bank points out the banks current forward PE of 13.4x is 3% above the average of the last five years, while also drawing upon the same relative measure to note a -9% discount to non-bank industrials over the same five years.
Another point Deutsche notes is that given the recent troubles at CBA, that bank’s seemingly perennial PE premium over its peers has now been eroded, meaning the dispersion between the PEs of the four majors is now significantly lower than the five year average.
Which brings us to relative valuations between the banks themselves.
NAB’s result was the least well-received by the market, not because it was any worse on an underlying basis than peers but because the bank announced a costly increase in investment. A month ago, the market had priced NAB to within 1% of the FNArena database consensus target price for the bank, but as the above table shows, the gap has now blown out to over 6%.
Subsequently, ratings upgrades have taken NAB to a consensus top pick from a prior second spot, knocking off Westpac. ANZ and CBA remain at three and four respectively but last month, at the height of the Austrac scandal, CBA had opened up a very unfamiliar -3% gap to its target. Now it is back at a more recognisable 2.6% above target.
CBA’s earnings update received the most positive market response, despite the bank having to shift money aside to cover (hopefully) whatever the regulator may apply in fines. This remains a point of uncertainty for CBA.
ANZ’s earnings growth is expected to lag peers in FY18 but the bank’s program of simplification and subsequent divestments will put the bank in a strong capital position. Westpac will, continue to do what Westpac does. Both ANZ’s and Westpac’s gap to targets is little changed from a month ago.
Last month’s FNArena bank update was entitled It’s all About Politics, highlighting a prevailing risk to all the banks, irrespective of earnings outlooks, of greater regulatory and political scrutiny. While we await what fate might befall CBA, we also note the banks have been swift in settling with APRA over their alleged collusion on fixing the bank bill swap rate (BBSW).
The government recently slapped the levy on the banks to head off increasing calls for a bank Royal Commission. The Opposition has made it clear that were it to win government, a Royal Commission would sit atop the to-do list.
Between now and the previous FNArena report, politicians have been falling like ninepins. When the dust settles, either one party or no party will hold a majority. If the required by-election tally increases further, the suggestion is a full election, or maybe even full double-dissolution election will be unavoidable, with Labor leading 55/45% in the two-party preferred polls.
A Royal Commission is all the banks need right now.
Ord Minnett does not cover Australian banks in-house, but instead whitelabels research on the sector by JPMorgan.
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