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Little Relief In Sight For Banks

Australia | Aug 05 2019

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

Australia's banking sector is under pressure amid soft loan growth, a squeeze on margins and a reinvestment burden. Brokers are not yet factoring in much of a recovery.

-Too early to be confident in a post-election rebound for the banks
-Borrowers likely to use lower interest rates to reduce existing debt
-Action to support bank share prices may be viewed favourably

 

By Eva Brocklehurst

It's no surprise that Australian banks have underperformed the broader market since the reduction in official interest rates in June. The issue for brokers now is whether a bottom for the banking sector is moving into view.

Movements in term deposit spreads versus the Reserve Bank's cash rate were mostly negative in July, when the second cut to official rates occurred. Ord Minnett is concerned about this, noting the widening in short-term term deposit spreads has been particularly pronounced on a three-month view.

The broker suggests assets spreads are under pressure amid potential for more cuts to the cash rate, noting the combination of subdued loan growth, downward pressure on margins and a reinvestment burden mean the banks are in a downgrade cycle.

Morgan Stanley also assesses the re-pricing of standard variable mortgages has not been sufficient to offset the lower earnings on free float and the squeeze on deposit spreads from the June/July cash rate reductions.

Housing loan growth appears to have stabilised at record lows but brokers suspect it is too early to be confident in a post-election rebound. System household deposit growth is subdued, at around 5% in June. System housing loan growth fell to 3.7% in June, with major banks' component growing at just 2.0%.

While the federal election outcome has reduced the tail risks and the reductions in official rates have improved housing market sentiment, Morgan Stanley still expects other factors will prevent a material rebound in loan growth.

Households are more leveraged and new responsible lending proposals from ASIC mean further increased scrutiny of bank expenses. Hence there are constraints on loan-to-valuation ratios, amid softer house prices and more conservative valuations.

Credit Suisse agrees, noting there is still no sign of a recovery in financial aggregates data. Total credit provided to the private sector by financial intermediaries increased by just 0.1% during June, housing credit increased 0.2% and business credit fell -0.1%. While being positive on business lending, expecting aggregate credit growth of 4.3% in FY19 and FY20, the broker believes a modest slowdown in housing will weigh.

Moreover, Morgan Stanley expects more reductions to the cash rate of -25 basis points increments will be forthcoming and margin pressure will accelerate if the new "customer first" approach limits home loan re-pricing. Macquarie is cautious, too, about historical correlations in this regard, envisaging borrowers in the current environment will use lower interest rates to reduce their existing debt, rather than take on more.

With the ongoing intent by authorities to enforce responsible lending standards, previous offsets such as a proliferation of interest-only products are likely to diminish. Interest-only flow pulled back sharply in the September quarter of 2017, Macquarie points out, following the introduction of APRA's 30% cap. This has now stabilised.

While the broker accepts that application volumes improved materially after the federal election, increased activity is suspected to be directed to re-financing at lower rates, which is detrimental to bank earnings.

Falling interest rates undermine bank profitability, as margins are squeezed relative to deposit pricing elasticity. In the short term, Macquarie envisages downside risk to bank margins and believes that consensus interest income expectations are too high for the banks.

Citi suggests the investment community may need to set aside a likely messy set of upcoming results and focus on the outlook for FY20. While the election result brought renewed optimism, the direct impact of a stabilising property market, lower funding costs and the conclusion of the Royal Commission impact will be absent from the FY19 results.

Bank Stocks

Morgan Stanley downgrades National Australia Bank ((NAB)) to Equal-weight as the share price has risen by around 20% since the federal election in May. It has outperformed the other banks by an average of 6%.

The broker also cites revenue headwinds for the retail banking arm and the potential for re-investment under a new CEO, as well as little flexibility on capital. Macquarie highlights that National Australia Bank's housing credit growth has turned positive, as management's action has appeared to be successful in stemming a loss of market share.

Heading into reporting season, Macquarie envisages the highest downside risk is in Commonwealth Bank ((CBA)) and Bendigo & Adelaide Bank ((BEN)), given stretched valuations and an overweight exposure to segments with elevated revenue pressure.

In contrast, Morgan Stanley upgrades Westpac Banking Corp ((WBC)) to Equal-weight from Underweight, given the relative valuation support and more scope to mitigate the impact of lower rates. Ord Minnett points out Westpac has been the first of the majors to make a material change the way it advertises mortgage rates.

The bank has moved to a single $150,000-plus discount-to-standard-variable-rate tier from a multi-tier pricing structure previously. Rather than a genuine increase in discounting, Ord Minnett considers this an improvement in transparency, with advertised rates now reflecting more realistic discounts.

Second-tier banks already operate with this approach and the broker suspects other major banks may follow. This will drive modest margin pressure over the longer term, although Ord Minnett cautions against over-playing the impact on margins.

Ultimately, the broker considers the move by Westpac is good for customers and long overdue, as it addresses some of the concerns of the ACCC about clarity in mortgage market rate pricing.

Soft trends are likely to dominate in the near term with respect to fee income, loan growth and competition for the front book. Citi suspects management action, in the face of these challenges, may be required to support Commonwealth Bank and Bendigo & Adelaide Bank share prices. Specifically, cost management programs and capital initiatives could be viewed favourably.

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For more info SHARE ANALYSIS: BEN - BENDIGO & ADELAIDE BANK LIMITED

For more info SHARE ANALYSIS: CBA - COMMONWEALTH BANK OF AUSTRALIA

For more info SHARE ANALYSIS: NAB - NATIONAL AUSTRALIA BANK LIMITED

For more info SHARE ANALYSIS: WBC - WESTPAC BANKING CORPORATION