Banks in Oz: Margins, Buybacks And Bond Yields

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Low interest margins and higher costs have dogged the banks so will the upcoming reporting season throw up any positive surprises?

-Better outlook for the banks embedded in rising bond yields
-Yet beating expectations in the upcoming reporting season may be difficult
-Impairments expected to normalise in current half year

By Eva Brocklehurst

Updates from the banks in Australia have been soberly interpreted over recent months amid the potential for lower interest margins and higher costs. The market appears to be accepting lower margins both now and in the near future, as well as higher costs over FY21.

Margins and expenses are expected to be the focus in the upcoming reporting period, and Macquarie continues to envisage a risk for pre-provision earnings to be skewed to the downside. While offsets to margin headwinds are scarce, the broker observes the impact of lower interest rates is diminishing as bond yields have risen across the 3-7-year curve over the past month.

This should provide some support for bank margins by FY23. On the expenses side, Macquarie expects short term disappointment and a better performance longer term, finding limited appeal in the sector currently but recognising the benefits from rising bond yields.

Morgans suspects subdued markets income, stemming from low volatility in currency and interest rates could be somewhat offset by M&A activity such as loan syndications and debt capital markets.

The broker assesses the pressures from low interest rates are easing amid rising swap rates, which has resulted in recent re-pricing of fixed rate loans. This is broadly neutral to margins at this stage but there is scope for re-pricing of fixed-rate mortgages if swap rates continue to rise.

Low-cost customer deposit growth is expected to stay strong relative to credit growth and this should have a positive effect on margins.

On the housing front, Morgans notes system home loan growth has been running at around 7.2% per annum and, while the recent tightening of macro prudential requirements by APRA (Australian Prudential Regulatory Authority) may temper the acceleration of home loan growth, it is unlikely to be enough to take this below 7.0%.

JPMorgan forecasts flat to negative underlying revenue growth amid subdued markets income. Net interest margins should be solid for the majors in the September quarter, with the broker noting system loan growth has rebounded strongly and recent increases in swap rates suggest the outlook is a little better.

That said, JPMorgan expects underlying net interest margins will be down on average by around -2 basis points half on half, with National Australia Bank ((NAB)) projected to be outperforming the others. The broker factors in margin pressure from markets income and higher liquidity.

Yet a pick up in credit growth for the major banks is expected in this current half-year, as housing growth has been particularly strong in Australasia and non-housing credit has stabilised.

Citi notes the sector has performed strongly in relative terms yet in absolute terms it's expensive. Hence, beating expectations appears difficult at this point. The broker cites regional banks, which did not do well in recent results, and the fact the gains by Commonwealth Bank ((CBA)) in reaction to its results were largely attributable to a record buyback and subsequently were given back.

The positive parts of the outlook such as low bad debts and capital management are now incorporated into expectations, yet share prices appear to be running counter to the soft reporting season that is expected.

The implication is quite significant and Citi suspects the banks have provided refuge from some of the earnings downgrades in other sectors such as resources.

Capital management initiatives already outlined have generally been in line with JPMorgan's expectations, although National Australia Bank and ANZ Banking Group ((ANZ)) have opted for a more immediate timeframe than previously anticipated while the buyback from Commonwealth Bank was larger.

Impairments are expected to normalise in the current half-year for the banks, reflecting a low uptake of loan deferral programs and solid economic conditions. A further removal of restrictions as well as the opening up of state and international borders should help small-medium enterprises (SMEs) deflect any potential defaults.

Westpac Bank

Citi believes the best way to manage the short-term risk is to look through the volatility and focus on the medium-term and this is best achieved by Westpac Banking Corp ((WBC)), its sole Buy rating, which has the opportunity to extract costs in the medium term.

Westpac will report its results on November 1 and JPMorgan agrees the commentary regarding the outlook for costs will be closely monitored, given the work required to reach the bank's -$8bn FY24 cost reduction target.

Still, the broker expects headwinds to margins from front book re-pricing and the impact of mix from growth in fixed-rate lending will be most pronounced for Westpac. A $5bn off-market buyback is also anticipated, to ensure there are sufficient reserves to deal with the likely negative effects from the capital changes by APRA.

While Westpac has had a volatile period recently, momentum has been restored to the balance sheet, in Credit Suisse's view, and a number of hurdles in relation to the disposal of specialist business have been surmounted.

Morgans expects Westpac's net interest margins will contract -3 basis points in the second half partly because of the drag from treasury and markets. Excluding this, the main pressure on margins will be related to home loans and the differential between the front and back books as well as the impact of customers switching to fixed rates from variable rates.

The broker expects the bank will be a greater beneficiary of rising swap rates through its replicating portfolio and will also be able to take advantage of a jump in three-year and five-year swap rates. Morgans, too, continues to expect a $5bn off-market share buyback.

ANZ Bank

In the case of ANZ Bank, which reports on October 28, JPMorgan expects it may do better in terms of the revenue impact from market volatility, given a diversified business, both in terms of product and geography.

The broker expects a net interest margin of 1.62% and suggests costs could be an area where the bank attracts a lot of attention. ANZ Bank aspires to cut -$8bn in costs, which JPMorgan believes is more credible than Westpac's target.

The broker is concerned, nonetheless, about the length of time it will take to turn the Australian mortgage business around, noting ANZ Bank's Australian housing balances are down -1% since March 2021.

While ANZ Bank is likely to cite higher pay-down rates, one of the reasons for this contraction in its home lending book, Morgans agrees the turnaround times remain sub-standard and this will contribute to ongoing softness in new home loans.

Credit Suisse also highlights the mortgage balance sheet has gone backwards and so expects the focus will be on repair. The critical issue is the cost and time it will take and whether this impacts on cost aspirations.

As the front book has little momentum, one positive aspect could be that margins surprise to the upside. Credit Suisse is also wary of being too negative about ANZ Bank, given the stock's sharp discount to the sector.

National Australia Bank

Momentum in business lending is likely to be critical in order to maintain the recent performance of National Australia Bank's shares, Credit Suisse asserts. The bank's remediation project, "Apollo", overhangs the stock and could manifest in higher costs or more punitive outcomes.

National Australia Bank will report its results on November 9 and JPMorgan expects 3% revenue growth, a flat net interest margin and 4% non-interest income growth. The main item of interest should be the outlook for SME lending, given the recent lifting of restrictions and the potential opening up of international borders.

Morgans will be looking for above-system home loan growth from National Australia Bank as APRA data have shown its Australian home lending has grown by 3.2% from March to August 2021 which compares with system home loan growth of 3.0%.

Yet, the broker expects expenses will be at the top end of guidance, at growth of 2.0%, and there is upside risk to this forecast. A credit impairment benefit of $99m is anticipated for the second half and upside risk is also envisaged to this as Morgans believes the bank can reduce its collective provision coverage of credit risk-weighted assets.

Macquarie Group

Macquarie Group ((MQG)) is due to report its half-year results on October 29. Credit Suisse believes the bank is in a sweet spot as asset realisations have yielded significant gains. While it is too early for Macquarie Group to provide full year guidance, any indication of how equity under management is being deployed should support expectations for strong earnings growth.

See also, How Will Banks Fare If Housing Market Cools? on October 4, 2021.

Disclaimer: The writer has shares in Westpac.

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