Australian Banks: Headwinds And Tailwinds

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The conundrum for Australia’s major banks is that the benefits of rising RBA rates could yet be offset by the reason for those rate rises, being inflation and subsequent cost pressures for households and businesses.

-NIM upside, at last, for the banks
-Offset by lower loan demand
-And rising costs
-And bad debt risk

By Greg Peel

Since ANZ Bank ((ANZ)), National Australia Bank ((NAB)) and Westpac ((WBC)) reported full-year earnings in November last, and Commonwealth Bank ((CBA)) provided a quarterly update, bank analysts were looking ahead to inevitable RBA rate rises as inflation reared its ugly head.

The year had been a tough one for the banks, given a near-zero cash rate provided little scope for a reasonable margin between what the banks could borrow at (deposits, offshore funding) and what they could lend at (mortgages, business and other loans), known as the net interest margin (NIM).

Australian banks generate some 80% of their total revenue from net interest income, and therefore are highly dependent on NIMs to drive revenues.

Adding to NIM pressures was not only fierce competition between each other, but growing competition from non-bank fintechs, which together had gone from being a slight annoyance to a growing force.

In short, analysts assumed back in November the NIM situation would only deteriorate further before things got better, and getting better was reliant on RBA cash rate rises. Yet by February this year, when CBA reported its first half earnings and the other three provide quarterly updates, inflation remained relatively low, the RBA was thus remaining patient, and indeed, the banks together posted again-lower NIMs.

At the same time, costs were rising, particularly to cover regulatory compliance, cyber security risk and technology upgrades required to keep up with the fintech upstarts.

The one saving grace was that having put away significant provisions against covid risk to the economy from 2020, the reopening that stuttered through 2021 and into 2022, until an eventual “living with covid” strategy emerged, and loan losses not being as bad as feared, meant the banks could return part of those provisions to the bottom line.

This allowed not just for a return to decent dividends, but for share buybacks as well.

Here We Go

Australia’s March quarter CPI numbers jolted the RBA into losing its aforementioned patience and ignoring the federal election to provide the first rate rise this month, of 25 basis points to 0.35%. Another hike is expected in June.

Given the March quarter wage price index indicated wage growth remained under expectation, consensus has the RBA hiking by another 25 points in June, to 0.60%, although some believe the board could still go a full 40 points to 0.75%.

Either way, what the banks, and bank analysts, had been waiting for had finally arrived. A higher cash rate justified higher lending rates, and there was no great rush to raise deposit rates, so NIM expansion was set to become a reality.

NIMs still had to turn around from weak levels before getting back to anything resembling pre-pandemic numbers, so analysts were surprised how quickly NIMs were stabilising as ANZ, NAB and Westpac reported first half earnings in May and CBA provide a quarterly update.

The banks were still able to return more provisions, and thus maintain solid dividends and buybacks. Increased NIMs offered the prospect of increased revenues, but would these translate into increased earnings?

The Dark Side of Rate Rises

The reason the RBA is raising rates is due to rising inflation, but inflation is not rising because demand is strong in the economy. When cheap Chinese imports flooded global markets in the noughties, global inflation fell into a stupor. But the global economy was strong, so central banks hiked rates, at least up until the GFC.

It took a while, but eventually rates rose again as the world recovered from the GFC, with a few stumbles along the way. But then came covid.

And more recently, the war.

Inflation in 2022 is about constraints on the supply-side, not strength on the demand-side. This means the RBA is not hiking into an economy that is getting too hot, but into an economy that is settling back from a sharp 2021 rebound and now being hit by the rising cost of living, and the cost of doing business.

Given inflation drivers are currently out of the hands of governments (unless they provide too much fiscal support to fight a higher cost of living), central banks have no choice but to slow the demand-side to combat supply-side forces. In other words, the RBA has to slow the economy, when it was already at risk of slowing.

House prices have surged in Australia since the RBA cut rates to near-zero in 2020. Facing a bleak NIM outlook and strong competition, the banks were forced to offer record low fixed mortgage rates. These will provide a buffer for borrowers in the near term, until they expire. Those on standard variable mortgage rates are now feeling the pinch of rate rises.

Just as they struggle to fill the car, or feed the family. And surging house prices have led Australians to borrow as much as they can on a debt-to-income basis. The risk is the strain becomes too much. And the rate-rise cycle has only just begun.

Businesses, too, are feeling the pinch, particularly those for which a large proportion of the cost of doing business is fuel. It all adds up to the risk of mortgage and business loans going “bad”. It’s all well and good for the banks to enjoy the prospect of higher earnings via higher NIMs, but they still need the revenues to drive the earnings, and they can’t afford for borrowers to start missing repayments or worse still, bad debts leading to foreclosures.

It goes without saying that the higher the interest rate, the lower the demand for a loan. This flows through to, for one, inevitably lower house prices. And lower house prices could lead borrowers into “negative equity” – the value of their house is now lower than their mortgage value.

Demand Collapse

The Australian housing market has seen several cycles this century but at the end of the day, major economic shocks, such as the GFC, have indeed led to house price pullbacks but not any significant collapse in prices. And then each period of low cash rates (GFC, covid), have sent prices to ever new highs.

This has led to disappointment and frustration among those potential buyers itching to see prices fall to levels they can better afford.

Economists agree Australian house prices will fall as a result of higher interest rates, but don’t agree on just how far they will fall. Consensus is nevertheless somewhere between -10-20%, but not straight away. Rates have to keep rising before the strain becomes too much, hence it’s more of a 2023 story.

There are several factors that suggest prices will not fall too far, leading to a wave of foreclosures.

First is the aforementioned timing buffer provided by an historically high proportion of fixed-rate loans.

Second is the fact that given house prices have risen so far, so too has the equity in those houses. Hence it’s a long way down into negative equity. And a notable proportion of borrowers have continued to pay off their mortgages at the rate they were first charged, however long ago, rather than reduce their payments in line with lower variable rates.

Third is the pent-up demand that sits under the market. Just as stock market investors jostle to “buy the dip” when valuations come back to more reasonable levels, and play who-will-blink-first games as a result, so too will there be willing buyer ready for house prices to come down a bit.

Finally, and perhaps most importantly, is Australia’s historically low unemployment rate. As long as you still have your job and can thus pay your mortgage, the value of your house is irrelevant. You have a roof over your head and you’re not about to sell.

The only relevance in this scenario is the so-called “wealth effect”. It is well-known that when house prices rise, homeowners feel wealthier, and despite having no intention of selling their house, feel poorer when prices fall. The wealth effect flows through to demand for everything else in the economy, as homeowners feel they must tighten the purse strings.

Lower consumer demand leads to lower business earnings and then we shift from the risk of bad home loans to the risk of bad business loans.

But again there is good news. The economy is continuing to “come out of covid”. For the great number of businesses that survived through 2020 on JobKeeper, and stayed afloat during subsequent lockdowns (with some help from a sympathetic ATO), the desire to revisit debt-funded business investment is growing.

There is also good news in the fact that while the banks have been returning amounts of covid provisions to their bottom lines, they haven’t returned all of it. There is a regulatory requirement to maintain provisions anyway, but the banks still have some extra buffer against bad debts.

The Cost of Doing Business

The cost of doing business for businesses is rising with inflation. So too is that cost for banks.

Indeed, banks already had cost problems heading into covid, including remediation obligations driven by the Royal Commission, greater regulatory compliance required as a result of RC findings, and technology investment required to drag staid institutions kicking and screaming into the digital world, so as to keep up with low-cost, online fintechs.

And each other.

The cost of these costs, if you’ll allow me some licence, is rising along with inflation.

Since last year it had been the intention of the majors to reduce their everyday costs to a point they could more than offset their uncontrollable costs, thus reducing their cost bases overall. But rising inflation has made this goal ever more difficult, and that’s before we get to wage inflation.

Wage growth has remained stubbornly subdued so far – at least up to the end of March – but no one believes that given low unemployment, wages will not start growing more rapidly soon. Between them the banks employ some 40,000 staff.

To that end, the May reporting season brought surprise announcements from both ANZ and NAB that they were simply abandoning their cost reduction targets.

Westpac held onto its -$8bn reduction target, but analysts agree this looks overly ambitious, and more so given the bank admitted that target relies on an inflation rate of 2.5% (last 5.1%, forecasts for the June quarter around 6%).

So where does it all leave us?

Competing Forces

Analysts have not let go of the fact rising rates mean rising NIMs, and that’s a positive. On commenting on last month’s bank result presentation, Macquarie noted:

“The favourable rhetoric around the benefits of higher rates, with limited acknowledgement of the likely offsets, was one of the key surprises for us. However, this suggests that the near-term tailwinds should provide banks revenue upside. While we continue to see risks to FY23 expectations with deposit costs starting to rise, banks appear in the sweet spot in the short term.”

Wilsons concludes:

“We see the sector as being on the cheaper side of fair value, primarily as we believe earnings risks over the medium term are skewed to the upside – higher NIMs, and lower shares on the issue given further buybacks.”

Morgan Stanley is less enthusiastic:

“A better-than-expected February reporting season, the potential for margin support from earlier rate hikes, and Australia's defensive characteristics combined to see the major banks outperform in the March quarter. However, the P/E discount has narrowed, the benefit of higher rates is now factored into the outlook, housing loan growth is likely to slow, inflation is putting more pressure on costs, and a “quick and aggressive” tightening cycle increases tail risks [bad debts].”

The bottom line is the banks are facing tailwinds (rising NIMs) and headwinds (falling loan demand, rising costs, rising bad debts). As Citi puts it:

“A rising cash rate is set to accelerate revenue growth for all the Major Banks. This is likely to lead to a narrowing of the current revenue differences, as lending demand slows. Therefore, EPS [earnings] growth forecasts in the next few years will be dictated by each bank’s cost strategy, so long as asset quality [bad debt risk] holds up.”

Which Bank?

All banks will enjoy the same NIM tailwinds. Thereafter, as Citi suggests, it will depend on how each bank handles the headwinds.

Consensus, in the wake of the May results, was that ANZ did poorly, NAB did well, CBA was neither here nor there and Westpac came out looking the best given its determination to stick to its cost-out target, except that no one believes it is achievable.

With ANZ’s cost target abandonment leading to a sentiment reset, more realistic expectations should reduce the bank’s risk of ongoing earnings misses. With the lowest return on equity in the sector, ANZ will benefit the most from rising rates.

NAB delivered strong growth, has a strong balance sheet, leverage to higher rates and an ongoing share buyback, offering valuation support.

ANZ and NAB are also less exposed to mortgages and more to business loans.

CBA’s update offered no catalyst for a de-rating, but stronger mortgage competition and higher expenses limit the upside. And as always, analysts see CBA’s valuation to the other three as excessive.

While divesting of non-core businesses is part of Westpac’s cost reduction strategy, 2.5% inflation?

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
ANZ	5/2/0	25.37	29.56	15.49	– 4.9	0.1	68.9	5.6	8.2	9.4	69.6	6.1
WBC	3/4/0	23.54	25.49	6.28	4.6	2.7	77.5	5.1	19.8	12.4	72.7	5.7
NAB	2/5/0	31.09	33.42	4.74	7.7	16.5	71.2	4.6	11.4	10.2	70.5	5.1
CBA	0/3/4	105.09	92.08	– 13.58	– 8.2	5.7	70.1	3.5	5.5	11.7	74.2	3.9

This is how consensus stands at present. While NAB was declared the winner of the results season, it is subsequently well priced, offering the lowest upside to target.

The reverse is true for ANZ.

Westpac sits in the middle, with a cost-out caveat, while CBA has hardly seen a Buy rating this century.

Thus CBA’s four Sell ratings are somewhat entrenched on a relative valuation basis. No one in the FNArena broker database is prepared to put a Sell on any of the others, but a net 14 Hold (or equivalent) ratings to 10 Buys suggests an element of caution.

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