Weekly Reports | May 24 2019
Weekly Broker Wrap: banks & APRA; RBA cash rate; diversified financials; and building materials.
-APRA's lending rules changes likely to underpin property market
-Reserve Bank ratchets up chance of cash rate cut in June
-Large disparity in provisions for advice remediation across diversified financials
-Cautious outlook prevails in US housing market
By Eva Brocklehurst
Banks & APRA
The Australian Prudential Regulatory Authority (APRA) has proposed revisions to the lending rules, which should provide support for the property market and, in turn, the banks. The proposal, designed to loosen up the availability of credit, is for the removal of quantitative guidance on the level of serviceability, the floor rate, and an increase in the serviceability buffer to 2.5% from 2.0%.
Under the proposal, banks would be free to review and set their own floor, with guidance from the regulator. JPMorgan considers this a pragmatic response, given the differential that has opened up in recent years between mortgage rates and serviceability requirements, and should remove a binding constraint on some lending.
The broker suggests this will provide a modest boost to housing credit growth and a partial offset to ongoing credit tightening in other areas. It should also level the playing field a little between the banks and non-banks. Still, JPMorgan cautions against becoming too optimistic about benefits from the changes, given demand side factors.
Macquarie estimates that removing the lending floor would increase owner-occupier borrowing capacity by around 9% and investor capacity by 3-6%. If property prices were to stabilise or even rise from current levels, Macquarie envisages upside to conservative credit growth expectations.
Moreover, should the decision alleviate the pressure on the Reserve Bank to cut official rates it would be an additional positive for the banking sector. Nevertheless, the broker notes recent weakness in lending activity was predominantly driven by the investor group, which is not a significant beneficiary from the change in the floor.
Macquarie envisages limited upside for the housing market, although recognises that in the near term investor repositioning may affect relative share price performance. Credit Suisse agrees the changes are likely to be taken positively by the market, although this is not the only constraint on borrowing capacity.
Commentary from the banks has indicated that of -1% reduction in the floor could increase borrowing capacity by 10%. The broker believes, along with the re-election of the Coalition government, that APRA's proposal removes the majority of tail risks for the banking sector. Given their greater exposure to housing, Commonwealth Bank ((CBA)) and Westpac Banking Corp ((WBC)) are likely to be the main beneficiaries.
Banks have typically been using an interest rate of 7.25% to determine the ability of a potential borrower to service the loan. Shaw and Partners notes many owner occupier loans pay an interest rate of 4% per annum. The broker, putting the serviceability test at an interest-rate of 6.5% instead, calculates the new proposals could increase loans by 6% for owner occupiers, but the increase for investors would be more muted in view of the higher interest rates they pay.
UBS was surprised by this easing of policy by APRA and considers it a positive for housing, materially reducing the downside risk for the broader economy as well. However, given ongoing expense verification, this is unlikely to reflate housing on its own. Nevertheless, the broker revises down its forecast peak-to-trough drop in house prices to closer to -10% rather than -14%.
The more meaningful impact from APRA's proposed changes is on confidence, Citi asserts. While borrowing capacity would increase for all, only a small cohort borrow to their maximum capacity. Upgrader borrowers and investors alike may also be spurred on to increase their loan size, bringing more firepower to asset markets. Since the federal election and APRA's decision, Citi observes housing investors have had a dramatic reversal of fortunes with regards to credit availability and the tax treatment of housing investment.
RBA Cash Rate
UBS believes the Reserve Bank is almost certain to cut the cash rate by -25 basis points in June and probably in August as well. The governor, Philip Lowe, appeared unusually clear in his recent statement, saying that a lower cash rate would support employment growth and bring forward the time when inflation is consistent with the target, while the case for lower interest rates would be considered at the next board meeting.
The governor's speech signals to UBS a cut to the cash rate in June is the path of least regret to stabilise the economy. In the event the unemployment rate does not move lower with current policy settings, the governor cited further options including additional fiscal support through expenditure on infrastructure and structural policies that support expansion, investment and employment.
Morgan Stanley moves its forecasts for cash rate reductions to June and August from August and November. The broker notes the governor suggests an unemployment rate below 5% is desirable and achievable, and that monetary policy has a role to play.
From now on, the broker assesses sentiment is the key to upside, although the bear case remains live, linked to the extent of job losses. Morgan Stanley points out trade tensions remain a serious exogenous risk to the growth outlook.
The disparity in provisions for advice remediation across AMP ((AMP)) and its peers provides little comfort in regard to adequacy, in Morgan Stanley's view. Analysis reveals the disparity may reflect varying degrees of conservatism, different approaches to valuing losses as well as different stages in the process.
IOOF ((IFL)) is due to update the market in September on its fee for no service (FFNS) provisions following a statistically significant sample review. The risk for losses has heightened given the duration of the project. The broker points out the Australian Securities and Investments Commission (ASIC) states the burden of proof lies with the licensee to provide records showing service was provided, otherwise the client should be compensated. Morgan Stanley estimates IOOF's charge could be $200-400m.
UBS observes major platforms are shedding funds under management at an increasing rate, as advisers turn to more contemporary and independent offerings. Recent cuts to administration fees from the major providers are, in the broker's view, a short-term solution. UBS lowers earnings estimates for both AMP and IOOF to reflect the pressures and has downgraded IOOF to Sell.
Although platforms are only one component of the wealth management value chain, they are the largest contributor to profit and crucial to downstream investment and other earnings. IOOF is a higher relative exposure and has had a slower response on fees as well as greater advice remediation risk, in the broker's view.
UBS notes US building industry participants have expressed cautious optimism on activity in 2019. Almost unanimously, expectations are for low growth of 1-3% and there is no indication activity will go back to the 2015-17 rates of 7% per annum. The optimism is underpinned by a recent decline in US 30-year mortgage rates. There is also increased foot traffic, although conversion rates appear low.
Compared with prior cycles, UBS considers the supply of new homes is constrained by tight labour markets and migrant labour leaving the US, as well as infrastructure connection constraints. Local planning officers are also demanding higher quality homes and greater community integration.
New home construction is a key long-term driver of the share price for James Hardie ((JHX)), despite only one third of US volumes going into new homes. As 2019 housing activity is also likely to be weaker in Australia, UBS has downgraded James Hardie to Neutral. The company is facing issues that are common to a maturing business and this is weighing on growth. Boral ((BLD)) is facing the same headwinds but UBS considers this largely factored into the share price and there is also upside from fly ash.
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