Australian Banks: Of Rates And War

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Brokers agree Australian banks are set to benefit from eventual RBA rate rises, as long as they don’t lead to recession.

-War to put further pressure on inflation
-RBA remaining patient
-Banks a safe haven as long as economy copes
-Competition remains fierce

By Greg Peel

Back in November last, ANZ Bank ((ANZ)), National Australia Bank ((NAB)) and Westpac ((WBC)) reported full-year earnings, while Commonwealth Bank provided a September quarter update.

Despite the general relief felt at the time, having come out of delta lockdowns, the banks’ earnings results were disappointing. Westpac and CBA suffered significant share price falls on the day of their releases.

The reasons for the banks missing analyst forecasts could be summed up in one word: competition. Remember when politicians would constantly accuse the Big Four of being an oligopoly of collusion?

With the RBA cash rate at zero, the banks were forced to offer historically cheap fixed rates on mortgages in a surging housing market. Deposit rates on offer were almost zero, so there was nowhere further to go. Hence the spread between the rate banks could borrow at, and what they were offering to lend at (net interest margin), was compressed – more so than analysts had feared.

A bank could choose to maintain a higher net interest margin (NIM), but risk losing market share. It could offer the lowest rates in the market, but suffer on the revenue line. Between the Big Four, a balance played out, but they all lost.

What’s more, they weren’t the only lenders in town. Aside from competing between themselves and with the smaller regional banks, they were competing with new fintech players – online services with comparatively minimal costs.

And it wasn’t just a case of fintechs moving into the banks’ traditional lending space – the banks were competing with superior, up-to-the-minute technology. The stalwarts were forced to play catch-up on the IT front. Hence bank costs were greater in the period than analysts had forecast, which impacted further on earnings.

The good news was solid capital positions still allowed the banks to offer attractive dividends, and even fund share buybacks. The bad news was analysts could see no change to the sector’s prospects in FY22 (June-end for CBA, September-end for the other three). Indeed, they all assumed things would likely get worse before they got better.

The only saviour will be RBA rate rises, all agreed. At that point in time, the RBA was sticking to a 2024 expectation of the first rate rise, while the market was pricing in 2023. Hence analysts assumed NIM relief was ahead, but not until FY23.

Much has changed in the meantime.

War and Pestilence

In 2021, it was expected that the surge in inflation that began early in the year, due to covid-driven supply and labour constraints, would ease as vaccines were rolled out across the globe. Inflation, it was assumed, would be “transitory”, and would soon settle back. Then came delta.

Okay, it might take a bit longer, it was agreed. Then came omicron.

Suffice to say, by late last year the Fed had abandoned its “transitory” assumption and in January this year, delivered a complete policy about-face that sent global financial markets into turmoil.

That turmoil had Australian banks share prices plunging along with everything else. But With the Fed flagging the first rate rise(s) in 2022, rather than the 2024 also previously guided, it was assumed the RBA would soon have to follow suit. The rate rises bank analysts had been touting as a saviour for Australian banks in FY23 were now an FY22 proposition.

The banks had already begun to incrementally raise their rates.

Bank share prices bounced hard, until they released their results in February. Only after that did Russia invade Ukraine.

February Results

As analysts had predicted, NIMs continued to fall from the November result releases. Over six months, the average Big Four NIM fell -11 basis points to end-February on Bell Potter’s calculations, but split between ANZ (-8bps) and NAB (-6bps), being more focused on business lending, and CBA (-11bps) and Westpac (-18bps), being the big mortgage lenders.

Given dour assumptions heading into the releases, results were actually a bit better than feared. Earnings forecast upgrades followed, on higher NIM assumptions, lower than initially expected credit charges (bad debts) and cost-out strategies, UBS points out.

In the short term, noted UBS, writing on February 28 (invasion February 24), the outlook for the sector has become more uncertain amid geopolitical unease but against this type of backdrop the broker expects the banks to outperform given their defensive qualities and relative safe-haven status.

All hinges on NIMs, but acknowledging the current uncertain political outlook, Macquarie admits discussing bank margins at this time may seem trivial, but suggests that as inflationary pressures persist, the risk of rate hikes is likely to return.

The broker is tipping three rate rises over the next twelve months, which in aggregate with higher bond yields, add some 8-13bps to bank margins by the end of FY23, resulting in broadly flat margins. This is a conservative forecast, Macquarie suggests, as it assumes deposit rates will also rise (dragging on NIM upside).

It is however possible the banks will initially play a bit of catch-up, raising lending rates first and holding off on raising deposit rates until later, thus exceeding Macquarie’s shorter term NIM expectations. On the other side of the ledger, the broker notes, is ongoing stiff competition among lenders.

The Lendi Mortgage Pricing Index highlights new standard variable rates (SVR) stabilised in February at around 2.15%, compared to 2.45% in the second half of 2021, suggesting competition for mortgages has intensified even before RBA rate hikes begin.

The observation of UBS analysts is NIM compression has been roughly in line with expectations, being an average decline of -8-17bps, but the market, in the broker’s view, is still not giving the banks the full benefit of the doubt on NIM expansion from interest rate increases.

War and the Economy

Canaccord Genuity agrees with UBS that the banks are likely a safe place to be during the current uncertainty.

Australia is similar to elsewhere outside of Europe, Canaccord suggests, in that the conflict will have little direct impact on the economy, other than further boosting exports and inflation.

Hence plans for monetary tightening to combat inflation are unlikely to be derailed at this stage, and in Australia, which has not seen the huge inflation spikes suffered by others such as the US, the RBA still has “scope to wait and assess incoming information,” as the governor noted this week.

Higher interest rates could indeed weigh on the equity market, and more so on high PE stocks, but less on other stocks, Canaccord argues, such as the banks.

“The potential for improving margins, along with solid lending growth, a focus on containing expenses, and strong balance sheets, are why we’ve been positive on the banks and favoured them over resource stocks,” notes Canaccord.  

Commodities, and thus resource stocks, are a hedge against inflation, as commodity prices are what price inflation is all about, but banks are also a hedge against inflation as they benefit from the increased interest rates inflation brings about.

Up to a point.

As we’ve seen this past week, commodities might be a hedge against inflation but are highly volatile in times of war, especially in the 21^st century of rapid response to constant newsflow. The risk to the banks is one of central banks going in too hard, too fast with inflation-fighting rate hikes that tip an economy into recession.

This is of most concern in the US at present, while the RBA continues to play a “patient” game. But a recession is not, of course, good for the banks at all.

Competition

Assuming the Australian economy remains as strong as strong as it is currently proving, and the RBA remains cool and calm, the banks may still have to face the prospect of ever increasing competition as rates rise.

Macquarie cites data from January that revealed that while the likes of NAB and CBA saw 7% annual growth in mortgages, non-major banks saw growth of 11-30%.

The majors dragged down their own NIMs last year in the battle of the fixed mortgages, however it appears to Macquarie that on the removal of attractive fixed rates, for which the majors had little outside competition, market share trends turned.

Macquarie expects the majors will continue to lose market share, at least until interest rates rise.

Another issue for the majors, which does not apply to smaller domestic banks and other lenders, is potential trouble across The Ditch.

Kiwi Krunch

Macquarie continues to expect New Zealand to be a relative drag on major bank growth in FY22.

Citi suggests “quite the policy change” is emerging in NZ, as house prices and household debt have both risen sharply during covid. However, just as higher rates are to have a natural cooling impact, a range of other measures being undertaken, such as restrictions on loan-to-value ratios and responsible lending changes, are set to “turn the mortgage market on its head”.

Note that while the RBA has held fast on its 0.10% cash rate, and remains “patient”, the RBNZ has hiked three times since October last year, from 0.25% to 1.00%.

While the big Australian banks will benefit from a higher cash rate via NIMs, Citi sees the potential for significant disruption to the NZ mortgage market as a self-inflicted credit crunch looks set to collide with RBNZ measures and higher interest rates. While early days, Citi thinks mortgage credit growth is bound to slow and house prices will likely fall.

While the NZ subsidiaries are a smaller part of the Australian majors’ earnings base, they have driven a material portion of group earnings growth in recent years. ANZ & CBA will likely be most impacted, Citi suggests.

By Comparison

Following the November bank reporting season, Westpac was trading at a full -21% below its FNArena database consensus target price. ANZ was at -7% and NAB -3%, while CBA was trading 11% above consensus, as usual.

Hence, CBA scored the lowest consensus Buy/Hold/Sell of 0/1/5. All of the other three scored 2/4/0.

It is a truth universally acknowledged that no two bank analysts will ever have the same order of preference among the Big Four, except in the case of CBA.

Jump forward to today and we see only a slight change:

FNArena Major Bank Data					FY1 Forecasts				FY2 Forecasts
Bank	B/H/S Ratio	Previous Close $	Average Target $	% Upside to Target	% EPS Growth	% DPS Growth	% Payout Ratio	% Div Yield	% EPS Growth	% DPS Growth	% Payout Ratio	% Div Yield
ANZ	6/1/0	25.09	29.68	15.21	– 5.3	1.1	69.8	5.6	11.3	9.5	68.7	6.1
WBC	3/4/0	21.96	24.93	10.25	3.4	4.5	79.8	5.5	20.5	8.7	72.0	5.9
NAB	3/4/0	28.98	31.21	3.91	5.2	12.7	70.5	4.8	8.6	8.1	70.1	5.2
CBA	0/2/4	97.41	91.56	– 7.88	– 9.7	5.4	71.1	3.7	2.9	9.4	75.5	4.1

The first thing to note is that after a hiatus, UBS has returned to the business of bank analysis. Hence ratings ratios now add up to seven rather than six back in November, except for CBA, for which Morgan Stanley is currently research-restricted.

Other than that, we note CBA is in its familiar position, while NAB and Westpac are still rating equally, despite Westpac showing considerably more upside to target (10.3%) than NAB (3.9%).

The star on the block is nevertheless now ANZ, with 15.2% upside to target drawing six from seven Buy ratings.

If brokers agree on one thing, it is that ANZ is best positioned among the four to benefit from rising rates.

ANZ is also currently offering the highest dividend yield on FY22 and FY23 consensus forecasts.

Longer term investors should nonetheless note two realities: (1) CBA almost always trades at premium to the other three based on superior size and return on equity, and almost always draws more broker Sell ratings than anything else; and (2), preferences among the other three consistently come and go over time.

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