Banks: Has The Narrative Changed?

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While a ‘buy the sector’ trade has been working for bank investors, it may be timely to ask if now’s the time for an entirely different approach.

-Banks still have potential 20%-25% return over 12 months, according to Wilsons
-General preference for retail over trading banks
-Share buybacks more likely than special dividends

By Mark Woodruff

There’s little doubt it has been a rollicking good time for those bank investors who dipped their collective toes into very uncertain waters twelve months ago. 

Total shareholder returns certainly bear testament with ANZ Bank ((ANZ)) up by 92%, Commonwealth Bank ((CBA)) 69%, National Australia Bank ((NAB)) 79% and Westpac ((WBC)) 77%. This comes as the ASX200 accumulation index has risen 36%, over the same period.

Over the last six months, nominating which bank to buy based on product mix and other factors is now looking forlorn, when all along there was a ‘buy the sector’ trade on improving asset quality.

This brings us to the bank earnings result season just past, in which Westpac, NAB, and ANZ posted half-year results, while CBA, provided a quarterly trading update.

It now seems the sector is set for ongoing benefits from healthy balance sheets, improving dividends and favourable valuations, though the jury is out on whether there is sufficient impetus for a further re-rating. A muted post-results share price reaction for the banking majors suggests market participants are pondering the way forward.

At this juncture, it feels timely to regroup and pose a double-barreled question: What has been already been priced-in for bank shares and is there a new narrative for investors to follow?

Before answering such questions, let’s first turn our attention to both positive and negative outcomes from the latest bank updates.

Bank reporting season positives

Bank results revealed higher net interest margins (NIM), which benefited from cheaper wholesale funding costs, as well as deposit rate repricing. NIMs were up by circa three basis points half-on-half on average. In simple terms, this is the spread between deposit rates and lending rates. 

Morgan Stanley explains funding costs were the key margin tailwind, driven by deposit re-pricing and a deposit mix-shift. Banks have optimised their base and seen a positive mix-shift toward at-call deposits and away from term deposits. Furthermore, the banks have benefited from lower wholesale funding costs and access to the RBA's low cost Term Funding Facility (TFF).

These factors have partially offset a competitive mortgage market and impacts of the low rate environment on the banks, explains Credit Suisse.

The second main positive from the reporting season was the improvement in the capital positions of banks. They have benefited from lower credit risk weighted assets on an improvement in the economic outlook. 

Credit Suisse also sees the benefits of divestments still coming through for the banks, which should further strengthen their capital position.

There was also an upward trend in non-interest income. Banks are starting to see customer activity return as well as the end of a number of waivers imposed during 2020 at the beginning of covid-19. This has resulted in higher fee and commission income across the sector.

Finally, other positives included higher earnings from New Zealand and a pick-up in housing lending, as house prices rebounded and housing turnover increased. 

Bank reporting season negatives 

There was lower markets income as lower levels of volatility in the market saw fewer opportunities for the Treasury & Markets segments. This resulted in lower trading and risk management product income. Furthermore, there was the non-repeat of the mark-to-market gains of the high-quality liquid-assets seen in the second half 2020, points out Credit Suisse. 

Financial markets income in aggregate for the three major banks reporting was lower by -30% sequentially, in the first half. This represented 9% of total revenue versus 12% in the previous half year.

Non-housing lending also continued to decline across the majors in the first half, as borrowers continue to deleverage. 

The outlook 

The first half was one of the better reporting seasons banks have had in recent years. It was characterised by strong capital positions, improving funding trends and healthy provisioning levels. However, in the lead-up to the results, the market looked for improving pre-provision earnings growth, which in Macquarie’s view failed to materialise. This was largely due to rising expenses and markets income weighing on revenue.

In fact, a renewed focus on costs appears to have been driven by an inability to deliver revenue growth. 

While banks delivered revenue growth relative to the weak second half of 2020, as the covid-19 related headwinds started to unwind, when compared to the FY20 average, only ANZ saw revenue (excluding markets) rise, notes Macquarie.

Wilsons agrees with the lack-of-revenue problem and cites revenue growth across the banks as the most disappointing aspect of the recent results. 

Despite an improving economy, revenue growth in the second half averaged just 1%. This is despite economic momentum and housing credit growth accelerating in the half. The broker thinks this is the key reason that bank sector share price reaction was subdued through the result period.

Wilsons cites a lack of ‘new’ areas for potential earnings surprise for the banking majors and notes core earnings leverage to the cycle was absent from the results.

However, the broker forecasts bank revenue should begin to accelerate in the next half and banks can still outperform over the remainder of 2021. This outperformance will likely be tempered, relative to what we have seen over the last nine months. The pressure from falling NIMs (looking back over the longer term) should moderate, while the domestic housing cycle should see housing credit growth maintained in the mid-single-digit rate. This should ultimately translate into moderate revenue growth.

Australian banks have performed strongly since November 2020, yet have still lagged behind the recovery seen in global financials. This is partly due to lower valuation starting points for offshore financials going into covid-19 and more serious covid-19 interruptions in offshore economies.

From a valuation perspective, Wilsons' preferred measure of price-to-book, that removes noise around earnings, still suggests Australian banks are trading around -15% below long-term fair value.

If this gap were to close entirely over the next 12 months, this would imply a total return of 20-25% when both an ordinary and ‘special’ dividend are included. This is before any franking is included.

Relative to almost all other sectors on the market, banks are still trading below long-term historical averages. With both the economic and market set-up still favouring cyclicals versus growth and likely to remain that way over 2021, the broker believes the value gap can continue to close.

Additionally, bank sector return on equity (ROE) is still depressed relative to where it has been in the past. The broker believes an improvement in ROE can occur with both sides of the equation assisting higher earnings and a lower share count.

Also in the positive corner, Credit Suisse believes the banks now have greater balance sheet momentum with a pick-up in asset growth and well-managed margins. Meanwhile, Morgan Stanley estimates an ongoing benefit from deposit re-pricing and mix-shift could provide near-term support. All else being equal, every five basis point improvement in the NIM adds around 4-5% to cash profit on a full year basis.

What has been priced in for bank shares?

The normalisation of both provisions and capital has already been baked in to forecasts for the banking sector. As a result, the easy gains have been ‘banked’, with the real world set to overtake the accounting world, according to Citi.

For the real world, actual losses may interrupt the ‘glide path’ down from surplus capital and provisions. The landing of actual losses is going to be more determinative to how the next few results for the banks play out from an asset quality standpoint.

So now comes the hard part: Whereabouts within the banking sector should investors train their focus?

If provisions and capital are likely to normalise in the long run and this is already incorporated into forecasts, it makes sense to focus on which banks are going to have stronger core earnings when balance sheets have fully normalised. 

What is the new narrative for bank shares?

There was a distinct change in narrative during the recent reporting season that may have been overlooked by investors.

A reduction in risk weighted assets points to a more difficult footing to generate revenues going forward, outside of housing in the short term, according to Citi.

While the sector has re-rated on the back of broad asset quality improvement there are still spot fires of specific sector stress. These may become more evident as losses start to materialise after the withdrawal of substantial government support.

The leading question now should be: Which banks will have stronger core earnings?

Citi’s answer, from an asset quality perspective, banks with out-sized mortgage exposures will see a ‘smoother’ balance sheet normalisation story. This is in contrast to the business banks, which will need to work out a number of troublesome exposures over the next 12 months. To that end, the broker's preferred exposures are to Westpac and CBA.

Dividends versus Buybacks

The amount of capital return by the banking sector is likely to be significant.

Wilsons estimates a surplus capital range of 5.5-8.5% of market capitalisation or almost $30bn. Banks raised around 4% of market cap in equity capital and dividend issuance in 2020.

Additionally, with all the banks now releasing covid-19 bad debt provisions, this provides additional earnings and dividend buffers over the FY22-23 periods. So far, the provision release has been small, at less than 10% of what was built-up in 2020.

The broker suspects that banks will prefer share buybacks over special dividends due to long-term benefits to earnings per share (EPS) from reduced shares on issue, and relatively low franking credit balances. 

Buybacks would also reinforce the view that action to increase capital in 2020 was a temporary event. Therefore, balance sheets should not be weighed down with permanent measures such as a higher quantity of shares on issue. Share buybacks could be EPS accretive to the tune of 6%-9% across the banks for FY22, estimates Wilsons.

If banks were to go down the special dividend route, the effective dividend yield (ordinary and special) could be almost in the order of 7-9%, double the market's current level of dividend estimates across both FY22 and FY23.

Consensus Forecasts

FNArena Major Bank Data					FY1 Forecasts				FY2 Forecasts
Bank	B/H/S Ratio	Previous Close $	Average Target $	% Upside to Target	% EPS Growth	% DPS Growth	% Payout Ratio	% Div Yield	% EPS Growth	% DPS Growth	% Payout Ratio	% Div Yield
WBC	4/2/0	25.46	28.49	13.24	100.0	100.0%	65.9	4.6	2.4	7.2	69.0	4.9
ANZ	3/3/0	27.70	30.17	10.38	61.0	100.0%	69.0	5.1	7.1	3.9	67.0	5.3
NAB	1/5/0	26.37	27.58	6.10	100.0	100.0%	63.7	4.7	– 1.3	6.5	68.8	5.0
CBA	0/5/2	97.76	86.82	– 10.02	– 12.8	15.8	72.6	3.6	8.6	12.0	74.9	4.0

Following the prior bank earnings season in February (CBA posting full-year numbers and the other three quarterly updates), ANZ was the most preferred bank among FNArena database brokers, not just on average but with seven from seven Buy ratings. But by mid-March, ANZ's share price had just snuck over its consensus target price (-0.1% upside to target).

See Australian Banks: Strong Tailwinds (https://www.fnarena.com/index.php/2021/03/19/australian-banks-strong-tailwinds/)

Westpac was ranked second, still 4.6% shy of its target, NAB third but only 0.5% shy, and CBA, as always, fourth on -10.0% upside to target (implying CBA was well overvalued, but then it always is — a fact analysts have always failed to acknowledge).

Despite continuing to lead the sector rally to the present, target upgrades ensure CBA is today still 10% above the consensus target. The other three have only seen comparatively milder share price gains, which has led to a yawning gap now to target for Westpac (13.2%) and ANZ (10.4%), and to a lesser extent, NAB (6.1%).

Westpac is now number one consensus pick on that basis, albeit not quite achieving the seven from seven Buys previously enjoyed by ANZ in March. Westpac's, and CBA's, consensus targets have been increased over the period, with analysts favouring the bigger mortgage lenders, while ANZ's and NAB's targets have slightly reduced.

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