Thursday, May 18th, 2017
- In the current environment banks are not going to deliver more than low single-digit cash earnings growth. Investors should expect flat dividends in FY18. NAB remains the bank most likely to cut its dividend though it didn’t this time.
- Bank interim earnings results and Commonwealth Bank’s third-quarter trading update were supported by improving credit quality and elevated trading incomes while banking revenue growth was weak. In the subdued environment banks are optimising their balance sheets and controlling costs to support returns. Stronger capital positions ahead of APRA’s midyear announcement were another key positive. We are cautious on the sector but have confidence in the management of each major bank.
- Historically banks have been able to pass on higher taxes and funding costs. While ongoing strong competition and increasing political scrutiny make this harder, earnings damage from the Federal Budget’s new liabilities levy should be temporary. But banks are yet to decide how they will respond to the levy and there will be a lag before they can pass the levy on to customers. Expect a public fight between the government, banks and other large profitable sectors afraid of being the next target for tax revenue raising. This won’t be positive for short-term sentiment on bank equities.
- The model portfolio continues to own ANZ and NAB because they have the least exposure to mortgages, where growth is slowing, the mix of business is becoming less profitable with the new regulatory limit on interest-only lending, regulatory capital requirements are about to increase and arrears risks are rising – though the risks remain out in the medium term (FY18-20) with currently no deterioration in mortgage arrears outside WA.
- Overall the outlook for bank valuations is neutral to slightly negative and the adopted NROEs in our valuations remain well below consensus in every case. Investors should remain underweight the banks unless the Budget’s infrastructure spending and improving world growth drive a broad return of consumer and business confidence, in which case banks are leveraged beneficiaries of any acceleration in Australia’s economic growth. The model portfolio has only a 10% weighting to banks compared with 30% in the S&P/ASX 200 index. This expresses our view the Budget’s infrastructure stimulus is largely a re-announcement of existing projects, with a handful of new ones, and the benefits to confidence will be limited to the areas around the new transport infrastructure.
- In the absence of positive catalysts for share prices, banks are likely to trade only in line with or at discounts to intrinsic value. At current prices there is enough value in the major banks to justify a moderate weighting and in our view most of the de-rate from the reporting season and the budget levy is over.
- Interim interest margins largely disappointed against consensus expectations. Political scrutiny of mortgage repricing and ongoing competition will make it harder for banks to reprice from here. In contrast European and US banks do not face the same constraints as global yield curves gradually shift higher and become more positive. Investors should deweight ASX banks in favour of European and US banks with a preference for Europe given the slowdown in US credit growth.
|Upside risks for banks||Downside risks|
|The Australian economy accelerates in response to infrastructure stimulus||Mortgage arrears in mining regions worsen faster, driving higher provisions|
|APRA’s new capital requirements are no worse than consensus. Banks easily accommodate them||Wholesale funding costs revert higher as lenders take a more pessimistic view of Australia’s banks and economy|
|Digitisation and automation enable bank managements to accelerate cost savings||The budget levy is increased and further regulation, scrutiny and enquiries collectively strangle the banks|
|World growth forecasts continue to be upgraded and Australia benefits. Bank wholesale funding costs remain benign. Investor sentiment on large-cap equities remains positive.||APRA demands higher mortgage risk weights and capital than consensus expects|
|Price competition in principal and interest lending intensifies as interest-only lending falls 30% of new mortgage lending|
|The domestic economy decelerates to zero growth. Unemployment worsens and spreads. Business and household borrowers start to default|
|A major negative shock to the Australian economy from offshore, for example a hard landing in China|
|Multiple rounds of mortgage repricing push many borrowers into default|
Major bank equities have derated significantly over the last two weeks with a selloff in response to interim earnings results, a strong lead from Wall Street into Monday’s open with ANZ going ex-dividend but falling by less than its dividend, then the hit from the Federal Budget’s new major bank liabilities levy and finally a broad selloff this afternoon. In this report we present the main themes from the bank reporting season and explain what the new budget levy means for investors.
1H17 reporting season scorecard May 2017
|Share Price Discount to FY18 Value||14%||4%||7%||10%|
|FY18 Price-Earnings Ratio||12.2x||13.9x||13.0x||13.2x|
|FY18 Dividend Yield||5.6% fully franked||5.2% fully franked||6.1% fully franked||5.8% fully franked|
|Capital Return, CY17 to date||-4%||-1%||+5%||0%|
|Cash Earnings Change, 1H17 on 2H16||+6%||-4% (3Q17 on 2Q17)||+2%||+3%|
|1H17 Dividend||80.0 cents fully franked||199.0 cents fully franked||99.0 cents fully franked||94.0 cents fully franked|
|1H17 Dividend Growth||nil||1%||nil||nil|
|Net Interest Margin, 1H17||2.00%, down 6bp||2.11%, down 4bp||1.82%, steady||2.05%, down 6bp|
|Loan Impairment Charge as % of Loans||0.25%||0.17%||0.14%||0.15%|
|Tier 1 Capital Ratio||10.1%, up 32bp||9.6%, down 30bp (31/03/17)||10.1%, up 42bp||10.0%, up 50bp|
|Return on Equity||11.8%, up 90bp||16.0%, down 130bp||14.0%, down 30bp||13.6%, up 34bp|
* As at market close, 12/05/17
Banks and the Budget: Government hostility and appetite for revenue are obvious
The Budget included a surprise six basis point (0.06%) levy on the liabilities of the four major banks and Macquarie Group. The liability applies to all customer deposits over $250,000 and all wholesale (non-deposit) funding but not hybrids. There doesn’t seem to be any particular economic justification for the size of the levy, which instead seems to be the outcome of backsolving from recently reported bank balance sheets for the amount of new revenue the government wants to raise to assist with budget repair. The hostility towards banks at senior levels of the Turnbull Government is also obvious. The government thinks banks gouge their customers and do not pay enough for the implicit protection from failure government provides.
Banks are widely unpopular, have very little political capital with voters and are an easy target for politicians. The sector needs to think about how it will rebuild the public’s trust but before this can happen expect a public confrontation between the government and banks.
The risk of increases in the liabilities levy will weigh on bank share prices. A similar levy in the UK went from 5bp to 21bp. While its purpose was to reimburse taxpayers for bailing out UK banks in the GFC, the hike demonstrates a government’s willingness and ability to increase tax imposts on banks.
The levy puts some dividend risk back on the agenda, especially for NAB, the bank most likely to cut its dividend. If NAB cannot pass on the levy its FY18 payout ratio will rise over 80%, which is too high. The risk to dividends for all banks won’t be resolved in coming months and will depend on how revenue growth, credit quality and the new regulatory capital requirements evolve.
Banks would need to increase mortgage standard variable rates by around 20bp to fully pass on the levy. There will be opportunities in coming months to do some of this as banks pass on higher capital requirements and risk weights for mortgages, which APRA will announce in coming weeks.
Repricing for any reason will slow growth in retail lending, the highest-returning category for banks, which is not good for profitable growth.
ANZ disappoints on revenue
ANZ is trading off revenue and earnings for a stronger balance sheet. Interest margins and interest revenue disappointed because ANZ had to compete in the domestic market to raise more retail deposits to offset the loss of Asian retail deposits as the bank exits Asian retail. This was partly offset by a reduction in dollar operating costs, possibly unprecedented for a major bank. ANZ continues to reduce its exposure to institutional banking, where heavy discounting by foreign banks is crunching returns.
NAB back to its former reputation
NAB reported a clean result in line with market expectations. Interest margins were stable and revenue grew faster than costs. Loan impairment expense surprised on the downside. Revenue growth was soft. NAB is now two halves beyond its years of consistent disappointment and bad performance. Today it is stable, derisked, professionally managed and a vanilla exposure to banking conditions. For investors who have followed NAB since it started down its path of 30 years of strategic failure by acquiring Clydesdale Bank in 1987, today’s NAB is scarcely recognisable. NAB is back as the ASX’s top-performing business bank.
WBC has the highest exposure to interest-only lending
WBC delivered better-than-expected capital generation and controlled costs well but there was a lack of banking revenue growth. WBC has the largest relative exposure to interest-only mortgages (50% of total mortgages) and therefore faces the sharpest deceleration in mortgage lending growth as interest-only lending falls to less than 30% of new lending by the end of September. WBC also faces the worst adverse mix shift because interest-only lending is less price-competitive than principal and interest, and P&I loans amortise faster with the repayment of principal from day one.
CBA disappoints in 3Q17
CBA’s 3Q17 result fell short of expectations due to softness in trading income and Cyclone Debbie. Similar to peers, the improving capital position (before dividends) and organic capital generation were the main positives.
Key theme: Capital requirements to rise again
We expect APRA will require banks to achieve a minimum 10% ratio of CET1 to loans by the end of the decade. There will also be higher risk weights for mortgages, which increase the capital requirements by enlarging the denominator in the ratio. Our base case is banks will be able to reach the new targets via DRPs, holding dividend payout ratios lower for longer and tilting new lending away from capital-intensive categories.
APRA wants banks to be “unquestionably strong” but it also wants banks to be profitable and does not want endlessly more capital for capital’s sake. The regulator is well aware too much downwards pressure on ROE from more capital could push banks to take undesirable risks, for example by reducing lending standards to boost loan volumes and restore profitability. The regulator also abhors negative publicity and does not want to be held responsible for a house price downturn. A balance will be found.
ANZ’s and NAB’s relatively lower exposure to mortgages, where the capital pressure is coming, is why we own these banks and not CBA and WBC.
Key theme: Net interest margins – capital charges, funding costs, competition and the new budget levy all in the mix
In April the regulator APRA said it would publish midyear an information paper on its thinking about how much shareholder equity (Common Equity Tier 1, or CET1) and other high-quality capital banks should hold against their loan books. By definition CET1 held against mortgages, which are high-ROE for banks, has to be invested in something other than mortgages like highly secure government bonds, which earn lower interest rates (2.65% on Australian 10-year government bonds vs ~5% on a standard variable rate mortgage). This reduces interest margins, net interest income, earnings and ROE so banks will try to pass on any new capital imposts by raising rates for borrowers and reducing deposit rates. These changes could conveniently be rounded up to include some of the budget levy or it could be rolled into a round of loan book repricings the next time funding costs rise.
Previously banks had little difficulty passing on tax increases like the GST and carbon tax. The difference this time is the new ACCC enquiry into bank residential mortgage pricing, which will run until 2018 and increase scrutiny of mortgage repricings. Banks will have to be more transparent about their reasons and the government will not want to hear the levy is being passed on but it might have to.
The most likely outcome is flat 2H17 interest margins as the mortgage repricings of recent months have their first full six months’ effect, with the liabilities levy dragging until this is passed on and the adverse mix shift from interest-only to principal and interest mortgages also detracting. Banks will continue to increase rates for interest-only borrowers as they aim to reduce interest-only loans to a maximum of 30% of lending flow by the end of September, APRA’s deadline, by deterring sufficient demand. The levy should detract significantly but only temporarily from interest margins.
The consensus view is the wholesale funding cost pressures of late 2016 have abated. The risk is this isn’t the case and lenders to the banks take a more pessimistic view of banks and the economy.
The federal government has probably done enough in the Budget to retain the AAA sovereign debt rating for the time being. This is positive for banks, which earn an extra one or two notches in their own credit ratings due to implied support from government in a crisis. Should the sovereign rating be downgraded one notch to AA+, bank wholesale funding costs could rise 10-15bp with negative implications for interest margins.
The levy could stimulate price competition for deposits less than $250k, which are not levied. This would be negative for interest margins.
Key theme: Costs under control but have little flex downwards if revenue slows sharply
If revenue growth slows to just above zero investors might expect banks to cut operating costs to support earnings and returns. Unfortunately we see little room for this, which adds to our caution on banks. Regulatory and compliance costs continue to expand in response to the multiple enquiries into the sector and new rounds of engagement with the regulator. All the major banks are investing in new technology to enable automation and the digital interfaces and functions customers want. Banks are also trying to increase customer growth and loyalty by upgrading the customer experience. All this costs money and while it could be cut to support short-term profits, customer gains and attrition would deteriorate.
Key theme: Profit growth
Tight management of costs, and increasing opportunities to save costs through automation of processes, helped most banks to eke out cash earnings growth despite very weak revenue growth.
Key theme: Bad debt charges still very low
Despite 14% combined unemployment and underemployment, record slow wages growth and rising household costs, loan impairment expense generally surprised on the downside this reporting season. This reflects conservative lending standards over the last five years and buoyant conditions in the largest housing markets. Interest rates remain historically low, most mortgage borrowers have accumulated significant buffers, business credit quality is strong, the New Zealand dairy industry’s fortunes have improved and banks have managed their exposure to stressed mining regions though this remains the main trouble spot.
Key theme: Dividends have stalled
Across the sector dividends have stopped growing. ANZ, NAB and WBC held their interim dividends flat and CBA paid the only increase of a meagre one cent. The reasons are elevated payout ratios due to earlier dubious decisions to raise dividends, slowing revenue growth, uncertainty about capital ahead of APRA’s midyear announcement and subdued economic conditions.
As long as there is no recession or surge in unemployment, banks can probably hold their dividends steady for another year with NAB still the most likely to cut – which is why the stock trades on the highest yield of the four majors.
Key theme: Tighter lending standards
Banks have already substantially tightened lending standards over the last seven years in response to their own and APRA’s diminishing risk appetite. The new penalties for bank executives who disobey regulations create incentives to tighten lending standards further at the expense of volume growth and market shares.