Feature Stories | Nov 23 2022
This story features ANZ GROUP HOLDINGS LIMITED, and other companies. For more info SHARE ANALYSIS: ANZ
Six months ago bank analysts knew exactly what would transpire over the following six months. While the next six should also be positive, it’s a different story thereafter.
-Bank results featured rising margins and rising costs
-Margin tailwinds expected into FY23
-Headwinds to blow strongly thereafter
-Wage inflation a pervading factor
By Greg Peel
Ahead of the last bank reporting season, six months ago, when ANZ Bank ((ANZ)), National Australia Bank ((NAB)) and Westpac ((WBC)) reported interim earnings and Commonwealth Bank ((CBA)) provided a quarterly update, a completely blindsided RBA implemented its first rate rise post-covid, right before the election, due to a surprise jump in inflation.
At least, the RBA was surprised – nobody else was. Economists had been warning for months.
The hike was a great relief to the banks, which had wallowed through two years of a near-zero cash rate, forcing historically low mortgage rates amidst stiff competition and hence minimal net interest margins (spread between borrowing and lending rate). NIMs provide some 80% of bank revenues.
Now there was light at the end of the tunnel. The first RBA rate hike was not going to be the last, and NIM expansion was back on the agenda. If the banks lifted their mortgage and other loan rates really quickly (which they did), and their deposit rates really, really slowly (which they did), they could squeeze the most out of it.
Happy days were here again. The tailwinds were a-blowing. Bank analysts saw earnings growth ahead, and a purple patch for the banks, at least for a period. Not forever though.
There were also headwinds. NIM expansion is all well and good as long as you have the loan demand to provide the revenue boost. Falling demand works the other way, and given the headwinds of higher interest rates on loan demand, and rising inflation and a rising cost of living on households, that purple patch was seen as having a limited expiry date.
What’s more, rising rates implied an inevitable fall in house prices, and the risk of rising mortgage defaults amongst borrowers on too-high debt-to-income ratios.
Rising inflation also implied rising costs for the banks, particularly in wage costs. Between them, the banks employ some 40,000 workers. Bank costs were already on the rise, from Royal Commission-driven remediation and compliance costs, to technical upgrade costs required to head off the rise and rise of digital fintechs.
The general feeling among bank analysts was enjoy it while you can, as it’s not going to last.
Well, in the six months hence the ASX200 banks sector total return (including dividends) is about where it was six months ago. However, all global equity markets tumbled through June, as the Fed led the rate hike spree. Since mid-June, that index is up over 24%.
That was the set-up going into this month’s bank reporting season.
And so it came to pass
The banks did all enjoy increased NIMs over the ensuing period, milking it for all it was worth by immediately raising loan rates with every RBA hike – totalling 275 basis points to date – while ignoring depositors until only recently.
It was a case of who would blink first, but ultimately competition forced deposit rate increases, but with much healthier margins to loan rates than was the case when the RBA cash rate was 0.10%. The banks all reported strong NIM growth over the period (including an update from Commonwealth Bank), but despite a bit of variation between them, this was largely as expected.
Importantly, NIM “exit rates” remained healthy. In other words, NIMs were still on the rise as the banks moved into their new financial year (or new quarter for CBA).
Bank analysts therefore see NIM tailwinds continuing into the first half of 2023. But the RBA will likely continue to raise rates into next year, house prices have begun to fall but are yet to really tank, Australia is expected to avoid actual recession but an economic slowdown is inevitable, and after a bit of a post-lockdown spree, consumers are expected to tighten the purse strings once Christmas is out of the way.
Loan demand, for both mortgage and business loans, is expected to contract, competition will remain fierce, and analysts believe the NIM party will come to an end by the second half of 2023, if not sooner.
In a Fix
There are several reasons why the RBA has not been that concerned about a housing market collapse.
Aside from stubbornly low unemployment (as long as you have a job you can pay your mortgage), lockdown savings (now rapidly diminishing), interest rate buffers (not dropping monthly mortgage payments along with fall in rates from 2020), and surging house prices in 2020-21 providing solid equity buffers, historically low interest rates have led to an historically high ratio of fixed rate mortgages.
Fixed rate mortgages are immune to increases in bank mortgage rates.
But only for the life of the loan. Expiry will bring a step-jump to a new, much higher rate, and the bulk of mortgages fixed at low covid rates will expire over the next two years.
This will be a blessing for the banks. Those loans fixed at historically low rates are below what banks are now offering in term deposit rates, implying negative NIM. This will all be resolved when the fixed loans expire, and the banks will enjoy a NIM boost.
Aside from this opportunity only serving to intensify competition, it will also potentially lead to a notable step-up in mortgage arrears and foreclosures, if mortgage repayment ratios are just too high for households to cope with.
Particularly given Philip Lowe had assured borrowers he would not raise rates until 2024.
There will follow further pressure on house prices, in a self-fulfilling cycle. There is one mitigating factor, however.
Citi notes the last time banks were faced with borrowers under credit stress was the covid recession, and before that the GFC. Covid came completely out of the blue, and while the GFC was slow-moving, almost no one had seen it coming. This time around, rising inflation and resultant rising interest rates have been both predictable and measured.
Yes, the run of 50 point RBA rate hikes is unprecedented, but (assuming another 25 in December) it has still taken eight months to hike by 300 points, allowing time for the banks to respond accordingly.
The banks have thus increased their credit risk provision – put aside earnings as a buffer – but not by that much. The reason is they had already increased provisions in a rapid response to a pandemic that absolutely no one knew how it would play out. While Australia did suffer its first recession in 26 years in 2020, it was all over in a blink.
Citi’s forecasts assume a material pick-up in new impaired assets, but with the banks already holding full provisions, the end result is likely a more muted bad debt outcome than consensus currently assumes, which the broker thinks is factoring in a much larger stress event.
With bank balance sheets anticipating pending stress in the economy, which other sectors are not, Citi believes the sector should be in a good relative position.
But at what cost?
The increases in NIMs reported by the banks this season came as no surprise to analysts. Nor were increased costs a surprise, but the extent of cost increases did catch analysts out.
It is well understood the banks are still paying RC-related remediations, are still needing to spend on greater compliance so as not to be caught out yet again, and are forced to invest in new digital technology to keep up with the low-cost, online-only fintechs invading the space.
And to keep up with each other.
It is also understood that unlike fintechs, banks employ an awful lot of people. Wages growth in Australia remained subdued to the point of non-existent this past decade under a government determined to keep it that way.
This year wage growth is finally on the move. We’re still well behind Western peers such as the US, but that only suggests we still have further to go. Unemployment is just not rising.
Bank analysts were caught out this season by the extent of wage cost inflation.
In the lead-up to the interim result season six months ago, the banks were doing what they could to reduce “controllable” costs in order to offset “uncontrollable costs”, and back then wage inflation was only an expectation, not a reality.
But inflation does not only impact on wages, it impacts on virtually all costs. General cost inflation was already in full swing by May this year, even if this fact had escaped the RBA up to that point. The result was last season brought a surprise waving of the white flag by both ANZ and NAB – both abandoning their cost reduction targets as unrealistic.
Westpac held onto its cost reduction target, but analysts agreed that appeared unachievable, and more so given the bank admitted that target relied on an inflation rate of 2.5%. The CPI printed 5.1% in the March quarter, and 7.3% for the September quarter.
There was hence little shock when this season’s report from Westpac included increased cost guidance.
Westpac did still reiterate a determination to reduce absolute costs, and increased productivity is one driver. This determination stood in contrast to ANZ, which has decided to throw caution to the wind and redirect increased revenues into investment spending.
As an aside, Westpac cost reduction ambitions are apparent in my own town where last week the Westpac and St George branches merged into one. Westpac owns St George, of course, after bailing it out in the GFC.
As noted, analysts agree the banks will likely continue to enjoy the tailwinds of rising NIMs on rising RBA rates into the first half FY23 (to March), before headwinds begin to take over in the second half (to September).
Inflation may have tipped over in the US (yet to be confirmed) but it is still on the rise in Australia and our peak is not yet in view. The RBA has thus continued to hike as necessary but there is evidence of concern in the board’s decision to only hike by 25 points at each of the last two meetings rather than 50 points, as the data would suggest and as economists had assumed.
Back in the GFC, there was much overuse of the analogy of whether one pulls a band aid off slowly or rip it off quickly. The latter causes more pain, but it’s over and done with more rapidly. The RBA is worried about causing too much immediate pain, and the possible recessionary consequences, settling instead to act definitively but at a more measured pace.
Or as Paul Keating said to John Hewson, “I want to do you slowly mate”.
As rates rise further, NIMs can rise too. But as rates rise further, loan demand falls. Housing loan growth fell to a ten-month low 7.3% in September. Goldman Sachs expects growth to slow to 2.5% by the end of 2023.
House prices have fallen -7.1% from their peak in May, when the RBA made its first move, and over the last three months have fallen at an annualised pace of -14.6%, according to CoreLogic.
Economists expect prices to ultimately fall anywhere between -10% and -20%.
Lower loan demand – lower revenues, whatever the margin. But the banks can’t just keep increasing their NIMs. The lending rate war among them is ongoing but the deposit rate war is just heating up. When the banks next issue bonds to fund their loan books, they’ll at a much higher cost (interest rate) than the prior issue. Banks need deposits as well.
This means a squeeze from below on NIMs, just as loan demand is falling, and NIMs provide some 80% of bank revenues. Add in increased costs, and earnings are further eroded.
Hence bank analysts warn the party will be over some time in the next six months. Is the market taking this into account in current share prices?
UBS estimates the banks, as a group, are trading at a forward price/earnings ratio of 13x, which is in line with the historical average. However, further share price outperformance will need to be driven by positive earnings revisions.
In 2021, CBA hit an all-time peak of $110.19 per share. As I write, it’s trading at $109.79.
While bank analysts may agree with each other in sector-general terms, rarely do they agree on an order of preference between banks. This is evident in the table below.
|FNArena Major Bank Data||FY1 Forecasts||FY2 Forecasts|
|ANZ||4/3/0||24.76||27.54||11.62||– 3.7||7.8||65.1||6.4||– 0.9||3.1||67.7||6.6|
|CBA||0/4/3||106.58||93.28||– 13.23||– 3.2||12.5||71.5||4.0||– 1.4||3.0||74.7||4.1|
What we first notice is no one (among the brokers in the FNArena database) has a Sell rating on any of ANZ, Westpac or NAB. This is typical, as analysts shy away from putting a Sell on a big company as this might upset management, and have repercussions.
The rule does not however apply for CBA, as CBA is always seen by analysts as overvalued compared to peers, when in fact it almost never is. Hence, no Buys either. A negative upside to consensus target (ie downside to target) in the order of -13% is also pretty normal.
As Australia’s consistently most successful bank, I doubt CBA management could care less about the views of bank analysts.
But despite warnings about peaking NIMs and falling loan demand and rising costs, consensus still suggests share price upside for the other three, over twelve months, of 3-11%, which clearly informs the order of preference.
And lines up neatly with comparable dividend yields.
Of course, twelve-month target prices are not fixed for twelve months.
Outside of the FNArena broker database, Wilsons is a little more emphatic in its negative view of the sector. The broker and asset manager has taken its position in bank exposure to underweight from neutral, cutting the weighting of its bank investment to 16.5% of the ASX300 compared to a 21% market cap weighting.
What will Wilsons do with the funds?
Battery minerals. Wilsons is looking to increase its exposure to battery minerals in the belief the industry has significant upside potential in the next few years. To begin with, the broker has tipped the proceeds of its bank sales into Mineral Resources ((MIN)).
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For more info SHARE ANALYSIS: ANZ - ANZ GROUP HOLDINGS LIMITED
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For more info SHARE ANALYSIS: NAB - NATIONAL AUSTRALIA BANK LIMITED
For more info SHARE ANALYSIS: WBC - WESTPAC BANKING CORPORATION