Australian Banks: When The End Of The Trend?

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Australian banks have run up to historically high valuations, well above expectation. But the tide is beginning to turn, and brokers warn of several factors conspiring to affect a period of bank underperformance.

-Bank valuations reached historical highs
-Super inflows a prime driver
-Competition intensifying
-Signs of housing boom easing
-Rotation into resources

By Greg Peel

Six brokers monitored daily by FNArena cover the four major banks. Between them, they currently have fifteen Sell or equivalent ratings across the four, with seven Holds, and all but two Buys; one each for ANZ Bank ((ANZ)) and National Australia Bank ((NAB)).

Elsewhere, the two regionals Bendigo & Adelaide Bank ((BEN)) and Bank of Queensland ((BOQ)) attract nil Buy ratings, two Holds and nine Sells.

In contrast, Macquarie Group ((MQG)) and Judo Capital ((JDO)) enjoy more Buy ratings than Sell ratings, as does Suncorp Group ((SUN)), which has no Sell ratings, but is in the process of divesting of its banking division to ANZ Bank to become a pure insurance company.

The Australian bank index has risen 38% over the past twelve months, led by the majors. The largest bank, Commonwealth Bank ((CBA)), has risen 33% despite attracting only Sell ratings from brokers, and having done so for some time. The sector has generated an extraordinary total return of 50% over the last twelve months, Wilsons notes, despite a tepid earnings growth outlook and increasingly extreme valuations.

Major offshore banks have also posted strong gains over the last twelve months, Wilsons points out, which have been supported by the Fed’s pivot towards an easing bias in late 2023, and expectations that lower interest rates would support “soft landings” across developed economies.

This dynamic has been quickly priced into bank valuations, both on the ASX and globally. In an absolute sense, the ASX200 bank sector’s forward PE multiple has never been higher, led by index heavyweight CBA.

Perplexingly to Wilsons, CBA trades on double the PE multiple of JP Morgan which is arguably the highest quality bank in the world, while having a lower return on equity and offering a similar level of earnings growth.

So why have the banks just kept on rising? Clearly no one’s paying any attention to bank analysts. In the face of broker warnings, who just keeps buying?

You

…is the simple answer to that question.

New data which has been analysed by Macquarie shows domestic superannuation funds were the standout major buyers of bank shares in the twelve months to June. The data offer a breakdown between super funds and domestic investment funds (ie non-super investments) as well as households, offshore buyers and other sectors.

Super funds increased their ownership of the sector by 1.6% over the period to 29%. This equates to $6.4bn of investment over twelve months and $2.1bn in the June quarter alone. As the banks have not been issuing new capital, someone has to be on the sell-side. Macquarie notes selling has largely come from investment funds (who might be paying more attention to bank analysts) and offshore investors (who may be looking through a more global lens).

So why have super fund managers ignored said bank analysts and just kept on buying? The data, Macquarie notes, indicate super funds have not been increasing their allocations to the banks and indeed remain largely neutral on a mere 0.4% overweight. The reality is super funds have increased holdings to domestic equities overall by 18% over the year, whereas the market overall has increased holdings by 9%.

This implies it is fund inflows, not fund manager strategy, that is driving increased bank buying. The banks are such a significant lump of the ASX200 market cap that super funds, most of which are passive, have no choice but to increase their bank holdings as more funds flow in.

And there is no end in sight. In July this year, the government-mandated super guarantee increased by 0.5% to 11.5% of income and will increase again to 12% in July next year.

Rates Don’t Matter

When the RBA started hiking rates in 2022 it was assumed demand for credit would suffer, offsetting the benefit banks enjoy in margin improvement from higher interest rates. Mortgage stress in particular would lead to a collapse in house prices of some -10-20%, depending on whom you asked.

It hasn’t happened. The RBA made its last rate hike last October to 4.35%. In the year to August, private sector credit rose 5.7%. Within that, business credit rose 7.7% and housing rose 5.0%. Overall, credit growth remains resilient and is actually picking up modestly. This is likely to continue, Morgan Stanley believes, particularly if expectations of the first RBA rate cut grow stronger.

The twist in the tale is ongoing strength in housing could actually be an impediment to near-term rate cuts, Citi warns.

Despite the impediment of higher for longer rates, anything housing related continues to “hum,” Citi notes. House prices continue to rise, and credit growth continues to be resilient. The broker has oft been questioned recently as to how long this can be sustained, given an already considerable household debt burden and mortgage rates in excess of 6%?

The debt burden is ultimately a reflection of the income supporting it and Citi sees a considerable shift towards higher income earners being active in the housing market, which likely reflects inflation working through incomes in a tight labour market. The recent cohort of borrowers is of a higher quality than that of the previous housing peak in 2022, Citi finds, largely reflecting improved household incomes.

With an inability to meaningfully lift housing supply, Citi suggests it is likely housing credit will remain resilient along with house prices. The broker is nonetheless Sell-rated on the banks and, in a relative comparison, prefers the retail-exposed banks. CBA and Westpac ((WBC)) are the biggest mortgage lenders.

Will house prices just keep on rising?

Other than a slight early wobble, Australian average house prices have only continued to rise in the face of effectively seventeen RBA rate increases (each of 0.25%) since May 2022. Sydney and Melbourne initially led the charge, but more recently have lagged, allowing the smaller capital cities to pick up the ball and run.

This reflects an affordability shift Australians looking outside the two big cities for more affordable prices. As to when affordability or the lack thereof reaches a nationwide red line is unclear.

National prices increased again in September, to 6.7% year on year growth. That did represent a slight annual slowdown, Morgan Stanley notes. Auction clearance rates remain in the low 60%s, which is consistent with slight positive growth, but have been falling since the beginning of 2024.

The rental market also looks to be softening, from extremely tight levels. Listings have increased with the vacancy rate rising in the past three months, to 1.3% nationally. Morgan Stanley notes this has resulted in an easing of “asking rent” growth, which has flattened out in the past few months, with annual growth slowing to 6.8% year on year.

These weaker conditions imply some headwinds for the broader housing market, Morgan Stanley suggests, but will take some time to flow through to CPI inflation given lags – asking rents are still up 40% versus pre-covid but CPI rents are only up 15%.

The above would imply a peak has been seen. but the issue is supply. You may have heard this is a bit of an issue in parliament of late.

Weakness in construction continued in August as building approvals declined by -6.1% month on month, reversing July’s improvement and falling below expectations, driven by apartments. Approvals looked to have troughed (up 4% from a year ago) but at very low levels, Morgan Stanley notes, and with limited upward momentum.

The broker expects sustained improvement in building activity from here will be challenging prior to rate cuts being delivered.

Morgan Stanley suggests current housing conditions are likely to persist through the rest of this year. While an expected slowing in migration rates should reduce some of the housing under-build, the broker does not expect enough of a decline to completely offset this, which should see prices somewhat supported. Affordability remains a key overhang to activity and construction, and this is unlikely to meaningfully improve until rate cuts come through, something Morgan Stanley does not forecast until May next year.

Other forecasters are anticipating the first RBA cut in February. A few are toying with the idea the monetary loosening could start before Christmas this year.

What could derail the banks?

Rising house prices even in the face of higher for longer interest rates are a gift for the banks. But only if they behave themselves.

Deposit competition among the banks is not intensifying as Macquarie had expected, and may even be easing. Instead, it appears banks are competing on the lending side again. While lending competition generally favours banks versus non-banks, it still comes at the expense of returns, the broker notes.

Macquarie’s Lendi Mortgage Pricing Index appears broadly stable, but anecdotal evidence suggests banks are beginning to offer cashbacks again for select refinance deals. Also, some banks are competing more aggressively for larger mortgages.

With mortgage growth again diverging between the majors (ANZ and CBA continue to grow above system while NAB and WBC’s growth is weak), Macquarie suspects banks will need to pull the price lever again to avoid market share losses. Furthermore, based on feedback, similar pricing dynamics also occur for SME loans.

In Macquarie’s view, this potentially creates downside risk to broadly flat consensus net interest margins in FY25, which do not appear to incorporate lending competition pressures and the impact of potential rate cuts in 2025.

To pick up on noted bank divergence, Australian mortgage system growth was 5.5% in August, broadly in line with recent months, Morgan Stanley notes. But Macquarie Group (+19%), Bendelaide (+9.5%), ANZ (+7.0%) and CBA (+6.5%) grew mortgages above a bank average of 4.5%, NAB only managed 1.0% growth while Westpac (-0.5%) and Bank of Queensland (-5.5%) went backwards.

While competition among banks remains ever present, the breakout of mortgage wars for the sake of market share is a tide that sinks all boats, in terms of net interest margins.

That’s one issue that could derail the banks.

Earlier, Macquarie pointed out recent bank buying in the face of advice to the contrary has been driven simply by increased flows into super.

While super fund contributions and flow are likely to continue, Macquarie doesn’t see this driving ongoing outperformance of banks relative to the market as they are already broadly neutral. The broker sees the next potential flow catalyst being offshore selling, likely on macro sentiment, which would result in bank sector underperformance.

The China Syndrome

It has already been happening. In the last week of September, the banks underperformed the ASX200 by -6.5%.

Morgan Stanley’s earlier assumption had been that bank outperformance this year was partly due to a “safe have”‘ status within the Australian market, and that it’s been better to sell mortgages and deposits rather than iron ore or oil and gas. At the same time, the broker’s Macro team noted a firmer consensus of a soft landing and potential improvement in commodity signals could be catalysts for rotation out of banks.

When China’s economy got itself into trouble, largely due to a collapse in the Chinese property market, Beijing responded with little more than tweaks around the edges in terms of providing economic stimulus, even as experts cried out for more. The issue was China’s extensive debt burden.

Things have only gotten worse, so finally Beijing has bitten the bullet. The government has announced more significant stimulus measures, resulting to a turnaround in what were weakening commodity prices.

Banks and resources are the two biggest chunks of Australia’s market cap (some 60% between them), hence any step-up in investment in one typically leads to selling in the other. The money has to come from somewhere. Hence over history, the banks and resource sectors have tended to rise and fall in opposition to each other.

Add in the recent -50 basis point rate cut by the Fed, with the expectation of more to come and swiftly, and offshore factors are conspiring to lead to a switch to bank underperformance.

The average major bank PE multiple has recently fallen from a peak of 18.5x to 17.5x, Morgan Stanley notes, but is still above the ten-year average, the three-year post-covid average, and pre-2022 rate hike levels. The outperformance of banks versus resources has been significant.

Indeed, as at end September the banks were trading individually at 20-45% premiums above the ten-year historical relative PE despite having a poor earnings outlook, Macquarie notes.

When Things Go Bad

A key trend from August results, trading updates and disclosures from the banks is the extraordinarily low levels of credit impairment charges the banks are currently taking, this despite worsening underlying asset quality trends. Credit impairment charges at some 8bps in UBS’ view are low, with consensus expecting around 13bps and 14bps in FY25/FY26.

The debate continues about the sustainability of low impairment charges, with consensus increasingly accepting a structural change of lower impairments. While losses will likely stay low for longer, Macquarie believes it is too early to write off the possibility of higher bad and doubtful debts (BDD) charges.

Macquarie believes the flow-on impacts of covid continue to impact banks’ impairments. For example, the broker estimates impairment charges would have been up to $270m higher per half than reported if banks didn’t unwind the overlays they built during the covid period.

Macquarie finds it difficult to reconcile that just in a few years, banks’ risk assessment has changed, and adverse scenarios that banks presented (which underpinned their substantial loan losses in FY20) are no longer relevant. While banks still have more provisions than they can utilise, there has been a sizable drawdown over the last twelve months despite the economic outlook slowing.

If macro conditions deteriorate, banks will potentially need to retain their provisions and possibly rebuild them. This will adversely impact expected BDD charges, which are currently extrapolating a very benign period of credit losses for the foreseeable future.

Macquarie believes as the economy slows, impairments will rise, and risk-weighted assets will increase. In past cycles, banks started to build their provisions earlier in the cycle, but this time provisions are already in place, and write-offs tend to come when the economy begins to show signs of stress.

On the other hand, if wrong, the broker believes lending spreads will decline more than expected over the medium term and sees risk to pre-provision estimates in FY26 and beyond, coupled with the likely de-rating from current multiples that are more than three standard deviations away from their long-term average.

Relief from credit stress will no doubt come when the RBA begins to cut rates. However, rate cuts will put pressure on bank net interest margins. Macquarie estimates -5-9bps of margin impact from -100bps of rate cuts.

Banks trade at a steep premium to their historical averages, which differs from cycles, Macquarie notes, and could impact their performance.

Consensus

In Macquarie’s view, valuations and fundamentals are not conducive to continued outperformance in the banks, and the broker sees material downside risk to share prices from current levels, particularly as the economy slows and rates decline, supporting an Underweight sector stance.

Citi is Sell-rated on the banks but does prefer the retail-exposed banks.

Major banks’ operating trends have been better than expected in 2024, and investors have paid much higher multiples for their strong balance sheets and “safe haven” status. Morgan Stanley has lifted its price targets, but retains a negative stance given share prices imply nothing goes wrong in 2025.

With bank earnings multiples at all-time highs and the outlook for earnings growth still tepid at the best, Wilsons remains comfortable retaining a significant Underweight to the Big Four banks within its Focus Portfolio.

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