This story was originally published yesterday, but due to a technical error it was cut well short of its intended length. This is now being rectified by republishing it in full.
- The Brexit fallout
- Stiff competition
- Margin downside
- Capital concerns
By Greg Peel
Before the Brexit debacle, an interesting juxtaposition had opened up between major banks across the Pacific. US banks had rallied on the expectation of rate hikes, and Australian banks had rallied in the expectation of rate cuts.
The share prices of banks in both centres had fallen sharply earlier this year in sympathy with European banks, which were hammered due to their exposure to emerging markets. China, in particular, was clearly slowing, but the plunging oil price had sent the economies of the likes of Brazil and Russia into a tailspin.
Deutsche Bank managed to arrest what looked like a slippery slope for all European banks by buying back a big chunk of shares. The oil price then began to improve, and disaster was averted. This allowed bank investors in both the US and Australia to refocus on domestic issues.
In the US, expectations of a pending Fed rate hike grew. The central bank itself was still tipping up to three hikes in 2016. While US banks had become comfortably well capitalised in the post-GFC years, near-zero interest rates had meant little chance of decent earnings growth given low net interest margins. The prospect of Fed rate hikes was thus positive for US bank shares.
Bank valuations are a proxy for an economy, but more specifically, stronger economies mean higher interest rates, more credit demand, wider net interest margins and thus greater earnings. Yet in Australia, the story was flipped over.
Australian bank shares took a turn for the worse last month when bank profit results revealed a big jump in “single name” bad debt provisions, as well as concern for loan quality in the mining states. Selling soon quickly turned into buying nonetheless when the March quarter CPI result showed signs of disinflation and the RBA caught all by surprise with a swift rate cut in May. Economists immediately began to factor in two to three more RBA cuts ahead.
But if rate hikes are good for US banks, why are rate cuts good for Australian banks? Well, they’re not…in terms of net interest margins and profits. But rate cuts are good at easing pressure on bad debts, and in Australia’s peculiar mortgage world, in which 25-year loans are priced off the overnight cash rate, rate cuts provide the opportunity for Australian banks to “reprice” their variable rate mortgage books by not passing on all of the cut.
At least some earnings growth is thus created.
The rally in US banks helped the S&P500 back to all-time highs. The rally in Australian banks helped the ASX200 back to resistance at 5400. But then along came Brexit.
When the shock Brexit result became apparent, all global bank shares were sold off in a hurry given global financial uncertainty. The UK and European banks understandably copped the brunt, with share prices falling 15 to 20+ percent.
The big-name US investment banks have various levels of exposure to UK earnings. For Goldman Sachs for example, 20% of earnings is derived in Britain. It thus makes sense banks should be the worst performers in the post-Brexit sell-off on Wall Street, dropping 5.4%.
National Australia Bank ((NAB)) will have been breathing a serious sigh of relief last Friday that the Clydesdale Bank spin-off was done and dusted ahead of the Brexit vote. The Australian financials sector fell 3.8% as a whole on Friday. NAB fell 4%. CYBG Plc ((CYB)) fell 17%, and is still falling today. Take the Clydesdales, Henderson Groups and company out of Friday’s financials sector fall, and Australia’s major banks did not fall anything like the UK, European or even US banks.
With good reason. While Brexit has undeniably unleashed global uncertainty, and the nemesis of stock markets is uncertainty, Australia’s banks have minimal exposure to UK/Europe and offer solid yields in a growing economy.
But it’s not all wine and roses for the Aussie banks looking forward in domestic isolation. A glance at the following table reveals the majors are all facing falling earnings growth and dividend pressure. The other element that leaps out is the large gap to stockbroker target prices, with Commonwealth Bank’s ((CBA)) traditional premium still evident, but the table is based on Friday’s closing share prices and stockbrokers will now need to reassess their valuations.
In FNArena’s experience, when gaps to bank share price targets get this large, one of two things has to soon give. Either bank shares rally or analysts downgrade their targets. The question now is as to whether analysts will see a need to downgrade their targets due to something that has happened a world away. They may nevertheless need to downgrade based on the uncertainty factor and what analysts will call “reduced multiples”.
This is code for “the banks have been sold off so now our target looks a bit rich”.
But before there was Brexit, there was the Australian domestic banking scene and its own issues.
The State of Play
Earlier this month, Macquarie’s bank analysts “went shopping” to assess the state of the local mortgage market in the wake of stricter investment lending regulations, mortgage repricing, an RBA rate cut and the need to preserve capital.
The analysts found that there now appears to be a greater level of consistency across the banks compared to last year’s significant variability in borrowing capacity. On average they found lending capacity had declined by around 10% compared to twelve months ago, reflecting tighter lending standards.
Yet that said, international comparison found lenders in the UK and US appear to be more conservative. Talks with mortgage brokers revealed competitive mortgage discounting of an average of 140 basis points off published rates among the Big Four. Given that level of discounting, Macquarie estimates mortgage “front books” (new) are averaging a net 14% return on bank tier one capital, averaged across owner-occupier and investment loans, compared to 30% across mortgage “back-books” (old).
Such a pricing trend does not bode well for banks’ future returns, Macquarie points out. The analysts believe the banks will either have to start competing less aggressively or put more emphasis on cost-cutting if they are to preserve future profitability. If not, Macquarie sees some 13% impact on valuations even if a further 25 basis points of mortgage repricing is passed through to customers.
That said, the broker remains “slightly overweight” banks given relative yield attractiveness in the low interest rate environment.
Bank analysts agree the majors will probably look to further mortgage repricing once the federal election is out of the way – they do not want to draw any further electoral antagonism beforehand – and will no doubt reprice if further RBA rate cuts are forthcoming. This should provide some earnings stability in the next 6-12 months, Bell Potter contends, but the low interest rate environment is expected to persist for some time and will continue to dampen bank margin expectations.
At the macro level, tighter prudential and home lending constraints on banks suggests credit growth closer to two times the GDP growth rate compared to a 12-year average of three times, Bell Potter notes.
Standard variable rate (SVR) mortgages account for 80-85% of Australian home loans and an even higher proportion of new loans, Morgan Stanley notes – 90% at CBA and 87% at Westpac ((WBC)). One might expect borrowers would be looking more closely at fixed rate mortgages, despite possible further RBA cuts, given an historically low cash rate. But the banks were onto that game early, lifting the premium on fixed rate loans over SVRs.
The major banks have repriced their SVRs on average by 22 basis points for owner-occupier loans and 45 basis points for investor loans since May last year. However, the margin benefit derived is being eroded by aforementioned competitive discounting of up to 140 basis points for owner-occupiers. Thus Morgan Stanley is forecasting flat bank margins ahead, even after further repricing post-election and as a result of further RBA cuts.
On consensus estimates for price to earnings, price to book value, return on equity and dividend yield, Australian banks do not look expensive, Morgan Stanley declared, ahead of the Brexit sell-off. But such forecasts assume the status quo, and the broker believes risks remain skewed to the downside given weak income growth, falling investment and reliance in ongoing strength in the east coast housing market.
Margin pressures and increasing loan losses are key areas to watch, as well as dividend payout ratios. These remain elevated and further bank capital building is expected to be required from 2017, Morgan Stanley warns.
Impairment charges for bad and doubtful debts (non housing loans) moved to 54 basis points in the first half 2016 from 39bps in FY15, reflecting aforementioned “single name” and other specific areas of loan pressure. Morgan Stanley expects this measure to rise to 73bps in FY17 due to ongoing problems in the “pockets of weakness” and a mild deterioration in in broader business and consumer credit quality.
Then there’s the issue of capital, which has been hanging over the banks for some time. Despite having significantly lifted their tier one capital ratios from pre-GFC levels, the banks are awaiting a final decision on international “too big to fail” requirements and a final qualification of what APRA’s interpretation of “unquestionably strong” will be. The bottom line is the banks may need to increase capital to satisfy international rules and then add a further capital buffer to keep APRA happy.
Leading up to the May results season for the banks there was much anticipation of a reduction in bank dividend payout ratios as a form of capital preservation. A couple of years ago when the fallout from the GFC had eased and lofty bad debt provisions were no longer required, the banks were able to pay out higher and higher dividends and even pay special dividends in a race to see who could look the most attractive to investors looking for yield. But this year has seen bad debts back on the rise.
Yet only ANZ Bank ((ANZ)) has to date reined in its dividend payments. When Westpac and NAB did not follow suit during result season, there was much shareholder relief. But for bank analysts, it was only a matter of time. Earnings growth was slowing but already elevated payout ratios were by default still growing. Morgan Stanley has long been one broker convinced another round of bank capital raisings is ahead of us, and dividend payouts will have to come down beforehand to minimise the damage.
That said, the events of this past week have very much put global banks in the spotlight. Australia’s major banks enjoy steady loan growth, Morgan Stanley notes, high returns in retail banking through oligopoly mortgage pricing power, ongoing access to offshore funding, some flexibility of cost management and attractive dividend yields vis a vis cash rates. But the broker retains a negative stance on the sector, believing a better economic outlook is required before a more bullish stance can be taken.
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