Australia | Jun 22 2020
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The next 12 months will test Australia's banks as the economy hits its nadir and then commences a recovery. How will they fare this time?
-Wide-ranging support to the economy allows for a more positive view
-Duration of dividend reductions will reflect the strength of recovery
-Loan losses could escalate later in 2020 as stimulus is unwound
By Eva Brocklehurst
An inescapable fact from an economic downturn is that any credit crisis will always favour large, established providers, but how are the banks placed for a recovery this time?
Morgan Stanley believes the next 12 months will be a test of the banks' resilience as the economy hits its nadir and then starts to recover, while Goldman Sachs economists take a slightly more optimistic view now, given the wide-ranging support provided by both Australia's government and the Reserve Bank.
The pandemic initially meant major bank share prices fell by an average of -38% and underperformed the ASX200, as investors became concerned about an emerging loan loss cycle and the need for more capital, as well as the impact of even lower cash rates on bank profitability.
Then there came a rebound of around 30% because of the strong fiscal and monetary policy responses as well as a better experience from the pandemic so far in Australia. Still, as Wilsons points out major bank share prices are -25% below pre-pandemic levels while the equity market overall is down -15% from its February peak.
The broker believes a sustained improvement in earnings is needed for the banks to re-rate, particularly given the low interest rate environment and is far from convinced about the relative strength of the Australian economy versus the rest of the world.
Morgan Stanley believes the performance of the major banks will largely be determined by the strength of the eventual recovery, which in turn will be reflected in the duration of the reductions in dividends.
Moreover, the size of earnings downgrades and the impact on capital remain sources of uncertainty because it is still early in the cycle. Once the full impact of the downturn is clearer, bank performance should be driven by margin management, the pace of rebuilding and the level of sustainable returns.
JPMorgan incorporates a return to a slightly more normal cost of equity into its estimates, driven by an improving economic backdrop and the controlled nature of the pandemic in Australia.
Still, a market risk premium of 6.5% is retained on the basis that the cost of equity will stay high as long as uncertainty persists. On margins, JPMorgan also envisages positive trends, with data suggesting term deposit spreads are improving.
Yet, Goldman Sachs points out banks have not been able to re-price their deposit products down in tandem with the cuts to the cash rate so far in 2020, although re-pricing has accelerated since May.
With significant amounts of surplus liquidity in the system the re-pricing trend is likely to continue throughout 2020. Citi emphasises the fact the major banks retain superior deposit franchises and will benefit from excess liquidity.
As government support recedes, Citi asserts this will favour the major banks. Major banks, too, will retain a structural advantage from wholesale funding over the longer term. The broker believes Commonwealth Bank ((CBA)) is best placed and Westpac ((WBC)) less likely to reap the benefits.
From a valuation perspective, the bank sector appears to be reflecting fair value, Wilsons assesses, and the deep value that existed in April and early May has been priced out.
Morgan Stanley has concluded that higher losses stemming from regulatory requirements will need a further increase in bank provisioning, while impairment charges will remain elevated.
National Australia Bank ((NAB)) is expected to have the highest loss rate given its business mix and exposure to those industries most affected by the pandemic, and the broker downgrades the stock to Equal-Weight from Overweight.
Morgan Stanley, too, expects Commonwealth Bank to remain the leader on capital with Westpac lagging. Westpac is upgraded to Equal-Weight, given an improved margin outlook from lower funding costs amid less concern about loan losses.
Goldman Sachs agrees it likely the build-up in provisions has not yet come to an end, and assesses the sector is trading at what can sustainably earn a 10% return. ANZ Bank ((ANZ)) is downgraded to Neutral, as the broker calculates the stock only offers a 1% shareholder return and would become more constructive if cost targets can be achieved by FY22.
Bank of Queensland ((BOQ)) is upgraded to Buy as the broker is now more confident the bank can reach its target of a broadly flat net interest margin in the second half. The bank is expected to benefit from an improved deposit funding environment.
Wilsons speculates whether banks have taken too many provisions. The current bad debt cycle may turn out to be short, given the JobKeeper support package has turned out to be costing less than the government's initial estimates.
Provisions for bad debts were calculated in mid to late April and the broker points out this could mean banks have over-provisioned if the economy bounces back quicker than anticipated. This would then allow “deferred” dividends to be paid. Announcements regarding dividends are due in early August from both ANZ Bank and Westpac.
Morgan Stanley does not expect any more capital raisings from the banks, calculating that excess capital to the tune of $10bn puts the average CET1 ratios of the major banks ahead of the “unquestionably strong” target of 10.5% set by APRA.
While expecting each of the major banks will pay a final 2020 dividend the broker assumes the potential for more dividend deferrals, given the guidance from APRA. Dividends in 2022 are still likely to be around -25% below 2019, in Morgan Stanley's assessment.
In order for dividends to return to 2019 levels, the broker believes the average return on equity would need to recover to around 11% and pay-out ratios would need to be around 75%.
Morgan Stanley expects a deterioration in credit quality will be more widespread than during the GFC because of the impact of the pandemic on employment and household incomes. Still, cumulative loss rates as a proportion of non-housing loans are anticipated to be lower than during the GFC and at less than half of the previous recessionary levels (1990-92).
Citi anticipates a second material credit event in the second half of 2020, as stimulus measures are unwound. Losses are typically higher amongst those loans that have originated in preceding years as less collateral has built up.
The broker expects two distinct phases in the fall-out from the pandemic. Firstly volume momentum will return to the majors, and feedback suggests this is starting to occur. Some such as Macquarie Group ((MQG)) are focusing on loan to value ratios of less than 60%, interpreted as a "practical withdrawal" from parts of the market.
In the second phase, as market intervention recedes and monetary conditions tighten, spreads are likely to widen and this could mean restricted access to funding for smaller lenders.
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For more info SHARE ANALYSIS: ANZ - AUSTRALIA AND NEW ZEALAND BANKING GROUP LIMITED
For more info SHARE ANALYSIS: BOQ - BANK OF QUEENSLAND LIMITED
For more info SHARE ANALYSIS: CBA - COMMONWEALTH BANK OF AUSTRALIA
For more info SHARE ANALYSIS: MQG - MACQUARIE GROUP LIMITED
For more info SHARE ANALYSIS: NAB - NATIONAL AUSTRALIA BANK LIMITED
For more info SHARE ANALYSIS: WBC - WESTPAC BANKING CORPORATION