Oz Banks: Downside Risk Scenarios

This story features NATIONAL AUSTRALIA BANK LIMITED, and other companies. For more info SHARE ANALYSIS: NAB

Brokers weigh potential impacts on Australian bank shares from rising unemployment and falling house prices.

-Upside risk scenarios for unemployment
-Will mortgage defaults rise materially?
-Rising interest rate benefit versus macro backdrop
-Macquarie recently downgraded its bank sector rating 
-Risks for SME loans in housing-sensitive sectors

By Mark Woodruff 

As rising inflation, geopolitical issues and inflated asset prices leave central banks in a difficult position to engineer a soft landing, Macquarie has explored downside risk scenarios.

In research released last week, the broker’s base-case for Australia was for a soft landing, with unemployment rising by 1% to around 4.25%.

However, Macquarie increased its probability of a more meaningful recession to 20% from 10%. Under this scenario, the unemployment rate increases to 6-6.5% by 2023-24. The analysts assigned a 5% probability to an even more severe downturn, in which the unemployment rate rises towards 8-9%.

The unemployment rate has a strong historical linkage to impairment charges, explained Macquarie. Even if actual credit losses do not arise, banks will likely need to adopt forward-looking increases in their provision coverage as interest rates increase and the risk of increased unemployment rises.

The broker pointed out Australia has certain advantages relative to some overseas countries, which will lessen the impact of a downturn upon banks. These include exposure to soft and hard commodities and a relatively low starting point for government debt.

Moreover, Australian banks have continued to de-risk their balance sheets. Secured housing lending currently represents around 55-80% of bank exposures, compared to 1-2% for unsecured loan exposures. Also, collective provision coverage is currently well above the provision levels which have typically preceded downturns, observed Macquarie.

While credit losses are one driver of bank valuations, the broker pointed out banks typically experience an around -15-30% multiple contraction during recessions, most of which occurs in advance. Already, Australian bank multiples have declined by circa -12% following the recent share price de-rating. While it’s possible to see a further correction more in-line with the -25-30% declines for UK/US banks, relative outperformance against global peers is still expected.

Regarding business portfolios, Macquarie feels banks are better diversified and arguably de-risked after a prolonged period of subdued business credit growth.

Banks' mortgage exposures

While Macquarie forecasts a decline of around -15% for house prices, material losses for bank housing portfolios are not expected, despite an elevated level of gearing in the household sector.

The broker forecasts a moderation in housing credit growth through FY22 and FY23, until a nadir is reached later in FY23 as house prices and turnover fall following successive rate rises. By 2024-25 the growth rate is expected to normalise as turnover recovers and house prices stabilise.

Jarden also doesn’t envisage a significant rise in mortgage defaults. On the proviso interest rates don’t rise above 2.5%, recently released research from the broker suggests households in aggregate are well positioned to face higher interest rates and the average borrower has material buffers in place. 

As the unemployment rate is expected to remain relatively low, Jarden assumes most borrowers will continue to meet repayments, so the impact on realised loan losses will be modest. 

However, a significant share of highly indebted households will reduce discretionary spending materially, according to the analysts. With the flow-on effect of much lower consumption, there is expected to be rising risks for SME loans, particularly in housing sensitive sectors such as construction, retail and tourism/hospitality.

A fall in house prices by -15-25% raises the risk of negative equity, though research suggests to the broker this is generally not sufficient to drive defaults. For now, the labour market looks robust, and unemployment is only expected to rise modestly in 2023.

Including other household debts such a personal and SME loans, Jarden forecasts interest payments as a share of income will increase to 7.4% by the middle of 2023 from a record-low of 3.7%, while the total debt-servicing ratio (which includes principal payments) is likely to rise to 17% from 13%. 

As negative as this sounds, the broker cites RBA analysis showing 40% of borrowers will not face an actual increase in their repayments, even with a 200-basis point lift in interest rates.

Moreover, Jarden points to RBA data showing the share of highly indebted owner-occupiers with low repayment buffers has declined to slightly below 1%. Rising rents and low vacancy rates are also expected to assist. 

Elsewhere, a household savings rate of 11% (twice the pre-covid level) provides a good buffer, suggests the broker. This rate is expected to decline towards 5% as spending recovers and households utilise savings for higher interest payments and general cost of living.

Benefit of rising interest rates for banks versus macro backdrop

Despite the short-term earnings benefit for banks from rising interest rates, Macquarie suggests the longer-term outlook is clouded by lower forecast credit growth and higher impairment charges.

As a result of these rising interest rates, upcoming bank results have the potential to positively surprise on earnings, noted the broker last week. 

However, after combining this upside risk with a recent de-rating for bank shares due to macroeconomic concerns, Macquarie downgraded its Bank sector outlook to Neutral from Overweight.

A more severe recession was also incorporated into weighted valuations, and the broker lowered individual bank price targets by -10-20%. It typically takes around 12-18 months for banks to re-rate, even when a recession does not eventuate, and it’s not anticipated recent share price losses will be unwound until the economic outlook becomes clearer.

National Australia Bank ((NAB)) is the broker’s most preferred exposure and CommBank ((CBA)) the least from among the major banks. While the valuation multiple for the NAB appears full, there is thought to be further scope for a re-rating given changes made to the business mix and the current franchise momentum.

The rating for ANZ Bank ((ANZ)) was downgraded to Neutral from Outperform and the 12-month target was reduced to $23.50 from $29.50, partly due to an overweight exposure to both New Zealand and unsecured lending. The broker also queried the bank’s systems and processes, following ongoing market share losses.

For further Macquarie (target price and/or rating) changes across the major and regional banks please refer to FNArena’s Broker Call updates on Friday June 24.

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.

FNArena is proud about its track record and past achievements: Ten Years On

Click to view our Glossary of Financial Terms