The Wrap: RBA; Banks; Healthcare and Funds Management

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Rate cuts; bank earnings; surgery returning and fund manager consolidation.

-RBA set to cut rates but what about QE?
-How will RBA policy impact on bank earnings?
-Non-elective surgery returning post lockdowns
-Global funds management industry ripe for consolidation

By Greg Peel

How far will the RBA go?

It is widely expected the RBA will cut its cash rate to 0.10% from 0.25% next Tuesday, before rushing out to get a bet on. The overnight cash market is already trading close to the 0.10% level, so the RBA would not have to actually do anything other than make it official.

It is also assumed that in resisting a move to negative rates, the RBA will introduce quantitative easing to provide further stimulus, but here the quantum is less certain.

Strictly, QE means buying government bonds at the long end of the curve. Some say the RBA is already conducting QE, as it is maintaining the three-year government bond rate at a 0.25% level, which it has to do by buying bonds. It’s a matter of semantics – the RBA calls this a Term Financing Facility (TFF) as a form of Yield Curve Control (YCC) rather than QE per se.

As is the case with the overnight cash rate, the RBA does not need to enter the market to buy bonds if the market has already adjusted to a rate of 0.25%. If the board wants to lower the ten-year rate however, it will have to enter the market as a buyer. And it is likely the government will have to issue more bonds to meet the RBA’s demand.

Such bond buying is known as “balance sheet expansion”, and National Bank economists are forecasting an expansion of at least $277bn to be announced next week, of which $143bn will be actual QE, if the board’s employment and inflation targets are to be met.

Spreading these purchases across eighteen months equates to $2.5bn per week across the curve from three years to ten, compared to the government’s current issuance rate of $3-4bn per week. This should, by NAB’s approximation, reduce the ten-year yield by -20-25 basis points.

On current pricing, NAB estimates the market is pricing in a $150-200bn QE program. If this proves correct a rally in yields (lower bond prices) is unlikely to transpire, but there would be disappointment if the number falls short.

Such a QE program would not be as aggressive as those of the New Zealand and Canadian central banks, largely because the RBA’s TFF offsets. The RBA continues to suggest a move to negative rates is highly unlikely, but the RBNZ is considering going negative and the BoC has not ruled it out.

NAB believes were the Fed to go negative (bearing in mind Congress has not been able to agree on a fiscal stimulus package), then the RBA would come under pressure to follow suit.

NAB suggests the announcement of a QE program between $100-300bn next week would result in a US$0.5c rally in the Aussie if the amount is at the low end, and the opposite if at the high end.

Should bank investors be worried?

The conundrum for investors in bank shares is the double-edged sword of rate cuts. Providing stimulus for the Australian economy and thus reducing bad loan risk equals good, while squeezing net interest margin potential with ever lower rates equals bad.

A bank’s core earnings are derived from the net interest margin (NIM), which is the balance of what they have to pay in interest to depositors and lenders (bond holders) and what they can charge to borrowers via mortgage and other loan rates. A bank cannot take deposit rates into the negative – mattresses are too readily available and inflation is set to remain low for years – and they can’t stubbornly charge too-high loan rates as competition is too fierce.

In other words, every RBA rate cut/QE program compresses NIMs, and thus bank earnings ever further.

Notwithstanding near zero deposit rates, covid has sparked a surge in household savings to offset what were some of highest household debt levels per income in the world, given economic uncertainty and job insecurity. Aside from this cash rolling in, banks have been able to tap into the TFF for funding as they await bonds issued in previous years, at higher rates, to roll off.

The banks are awash with liquidity. “So what?” says the market. They can’t use it to make any money.

Citi analysts beg to differ:

“Against the rhetoric of rates are low so NIMs will fall, we see the benefit of lower funding costs able to offset a continuation, but not acceleration, of competition in the mortgage market. This sees our forecast NIMs materially above consensus in the outer years.”

The conclusion of Citi’s extensive and complex argument is that investors should consider future NIMs on an “ex-liquids” basis given that this current excess liquidity will partially run-down as the economy reopens, be channeled into lending growth and/or be used to replace wholesale funding when it rolls off.

Thus increasing earnings. The biggest beneficiaries in the financial sector of Citi’s argument, the analysts suggest, will be the majors.

Is it safe to go back to hospital?

Last week JPMorgan surveyed 300 Australians to learn their current attitudes to health services now lockdowns are behind us. The same survey was last conducted in June. Recall that the lockdowns halted all non-emergency surgeries and kept patients away from doctors’ waiting rooms.

More than 25% of respondents who had a procedure deferred or cancelled due to lockdowns have now had that surgery. 21% said they still intend to proceed with planned surgery, but not until there’s a vaccine. This is up from 11% in June. 4% said they have abandoned the surgery idea.

84% said were they to need surgery they would be prepared to go ahead now or in the next few months, consistent with 85% in June.

84% said they were comfortable visiting their doctor, and 95% via telemedicine, up from 76% and 89% in June. 85% waiting to have diagnostic tests (radiology/pathology) have already now done so or are about to.

Given the small proportion for whom covid remains too significant a fear, JPMorgan declares routine work to be back close to normal.

90% said they would probably get a vaccination.

Overall, JP Morgan remains confident that demand for inpatient and outpatient services will continue to lift now Victoria is reopening. This bodes well, the analysts suggest, for Ramsay Health Care ((RHC)), Sonic Healthcare ((SHL)) and Healius ((HLS)).

What of private health insurers?

Insurers had set aside provisions for the claims they expected would simply be deferred due to covid rather than cancelled. Medibank Private ((MPL)) conservatively assumed 100%. For nib Holdings ((NHF)) that number was 85%. Thus JPMorgan suggests such provisions appear to be sufficient, based on the survey, probably more than for Medibank, to cover pending claims.

On the flipside, 60% of survey respondents said they had private health insurance. Of those, 78% intend to keep it, 11% said they intend to downgrade or cancel their cover and the balance will make a decision based on the next premium rate increase.

Consolidation in Funds Management

Globally, notes Morgan Stanley, asset managers are being hindered by fee pressure, a shift to lower-fee products, growing regulatory and technology cost burdens, and growing churn within actively managed products.

That’s globally. Note Australia’s asset management industry has also been upended since the Royal Commission.

Asset management is a highly fragmented industry, the broker notes, with the top ten global firms controlling only 35% of the market between them, and thus appears ripe for consolidation in order to increase scale. Morgan Stanley sees product intermediaries and distributors also looking to vertically integrate into asset management to increase fee flow.

Yet many scale-driven acquisitions have not been rewarded by shareholders to date given mixed performance on growth. If M&A deals are based on scrip-swaps and earn-outs (a pricing structure in which the sellers must "earn" part of the purchase price based on the performance of the business following the acquisition), such risks can be mitigated.

Morgan Stanley sees merit in deals that help to advance a multiyear “journey” toward greater efficiency and strength in diversity. However, the market is more likely to view scale-driven deals as requiring proof of success before reward, the broker suggests.

The best deals will improve organic growth trajectory, expand the product portfolio in growth zones and extend distribution capabilities to new customer sets or geographies. M&A can provide scale, add capabilities, and improve bargaining positions with intermediaries.

With regard Australian listed asset managers, Morgan Stanley notes Janus Henderson ((JHG)) has a modest excess cash position it can call upon, but it does need to satisfy UK capital requirements. Janus Henderson is around 65% tilted towards retail clients which makes it attractive for M&A, but there is the issue of large Japanese shareholders who may not be so keen.

Culture is also important in asset management mergers, the broker points out.

Morgan Stanley notes that Janus and Henderson had almost no overlap in investment capabilities when they merged in 2017, yet several analysts left and one Emerging Market equity fund lost almost all of its assets.

Perpetual ((PPT)) has undertaken two acquisitions in 2020. The acquisition of US-based Trillium was relatively small but adds crucial ESG capabilities, the broker notes. Perpetual is proposing to acquire Barrow Hanley which would add scale, distribution and US/global product capabilities and provide a platform for further US growth.

Perpetual remains open to further bolt-ons.

Macquarie Group ((MQG)) is focused on organically growing its leading private market and infrastructure asset management businesses as well as diversifying away from fixed income towards higher margin equities. The group boasts a strong balance sheet and is open to further bolt-ons, having executed several deals in the past few years.

Morgan Stanley has an Overweight rating on Macquarie (bearing in mind asset management is only part of the investment bank’s activities).

The broker has an Overweight on Perpetual and an Equal-weight on Janus Henderson.

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