Following the release of the major banks' FY24 results, our sector view remains unchanged, with the Focus Portfolio retaining an underweight exposure to the major banks. 

The ‘big 4’ banks all reported a decline in earnings in FY24, largely in line with consensus forecasts. Most importantly, however, their results did little to alter our cautious stance towards the sector. Despite modest upgrades to consensus forecasts over the last month, the sector’s medium-term earnings growth outlook remains uncompelling in the context of highly demanding valuations.

This report explores the key themes from the banks' reporting season (with a focus on Westpac, ANZ, and NAB, which all reported last week) and their relevance to the sector’s earnings growth trajectory, while also discussing recent changes to the Focus Portfolio’s banks positioning. 

The portfolio’s underweight exposure towards the sector is unchanged. However, we have removed NAB (-4.5%) from the portfolio and redeployed the proceeds into the better valued banks: Westpac (WBC) (+2.5% to a weight of 5.5%) and ANZ (+2% to a weight of 8%).

1. Credit growth remains resilient despite restrictive monetary policy

Despite the ongoing impact of elevated interest rates, housing credit growth has picked up since mid-2023 to around the post-GFC average, while business credit growth remains above its post-GFC average. 

The unusual level of resilience in mortgage demand throughout this tightening cycle (despite restrictive monetary policy) has been driven by rising home prices (fuelled by population growth and constrained housing supply) and strong nominal income growth. However, the RBA has pointed out that while housing credit growth is sound, it is ‘not that strong’ and reaffirmed that financial conditions remain restrictive. 

We expect housing credit growth to remain stable around average levels in FY25, with the key swing factor being the timing and magnitude of RBA cash rate cuts. Delays to prospective rate cuts would likely result in weaker credit growth over the medium-term.

2. Moderating competition underpins stabilising margins

Competitive intensity in the mortgage and deposit markets was a significant headwind to net interest margins (NIMs), and therefore major bank earnings in FY24. These competitive dynamics were highlighted by Westpac (WBC), which (after varying its pricing throughout FY24) noted that when its pricing was above market, it experienced greater outflows.This demonstrates that pricing remains a key driver of the mortgage market. 

However, the stabilisation of ANZ and Westpac’s NIMs in 2H24 suggests that competitive pressures are easing. While competitive dynamics are inherently difficult to predict, the major banks have generally guided towards continued but ‘moderating’ competitive pressures over the next year. 

This backdrop should allow for relatively stable margins in FY25, which is already reflected in consensus estimates. 

Overall, we don’t see meaningful upside risks to consensus NIM forecasts over the medium-term, given RBA rate cuts are currently expected over the next twelve months and due to ongoing political pressure on loan rates. 

3. Bad debts remain low, but asset quality is deteriorating

Bad debts (i.e. loan impairments) have remained benign, despite elevated interest rates and cost of living pressures. However, asset quality (as measured by arrears – loans where interest payments are late but have not yet been impaired) weakened in FY24, with NAB showing the clearest deterioration as non-performing loans increased +17.7% in 2H24 (vs 1H24). 

We continue to expect bad debts to rise over the medium-term, given weakening asset quality metrics, which will be the key headwind to bank earnings over the next few years. The key factor that could drive upgrades or downgrades to consensus bad debt forecasts will be the timing and magnitude of RBA rate cuts, alongside the direction of home prices, unemployment, and nominal income growth. 

4. Strong balance sheets underpin strong capital returns

The ‘big 4’ banks all continue to enjoy strong capital positions. The sector remains very well capitalised, with CET1 (common equity tier 1) ratios ranging from 12.2-12.5% - well above APRA's target range of 11-11.5%, which has underpinned share buybacks from all of the ‘big 4’. While the banks are currently taking a conservative approach to their capital positioning, in our view there is scope for further capital returns to shareholders in FY25, which will be modestly (low single-digit %) accretive to EPS in the near-term.

In summary, stabilising margins, sound credit growth, and share buybacks will support earnings over the medium-term. However, this will be largely offset by the headwind of rising loan impairments. As such, everything considered, the sector continues to have a relatively unattractive earnings growth outlook, with all of the banks offering only low single-digit EPS growth over the medium-term. In this context, we continue to view bank valuations as excessive overall, with the ASX 200 bank index currently trading on a 12-month forward PE of 18.4, which is ~30% above its five-year average, and represents an uncharacteristic premium to the broader ASX 200 index.

The portfolio remains materially underweight the banks. However, we have removed NAB from the Focus Portfolio and upweighted Westpac (WBC) and ANZ, which both offer attractive relative value in a sector where valuations remain excessive on the whole.

Our rationales for these changes are explored below.