We still remain cautious on the outlook for the banks.
We have seen more evidence to support our view over the past week. NAB (NAB), ANZ (ANZ) and Westpac (WBC) have all reported half year results, which all share the same common theme: NIMs have peaked.
Our underweight to the banks is predicated on:
- NIMs peaked in 4Q CY22: the outlook for NIMs is tough in the context of a competitive deposit and mortgage lending landscape.
- Slowing economy: risks due to a slowing economy are not reflected in consensus net interest income.
- Earnings have peaked and we expect downgrades over the next 6 months.
Margins Underwhelm
The banking sector is unlikely to gain any further margin benefits from rising rates in the current monetary policy tightening cycle. NIMs looks to have peaked.
Australian banks generate 80% of their total revenue from net interest income and therefore are highly dependent on net interest margins to drive earnings. We expect that a 5bps increase/decrease in NIM typically leads to a 5% increase/decrease in cash earnings – a material impact on the bottom line.
On average, NIMs have increased 5bps HoH for WBC, ANZ and NAB. However, the NIMs for the banks that reported showed a NIM peak in the December quarter before falling back in the March quarter at a lower exit margin. The CBA update on Tuesday also indicated margins were still sliding.
The fall has coincided with intensified competition for deposits and in mortgage lending. We don’t think these pressures will abate anytime soon – a key reason for remaining underweight.
Higher Rates, Higher Competition
Higher interest rates provided some benefit to NIMs up to a point. Still, the past 6 months have proved when interest rates get high enough and cost of living pressures rise, borrowers and savers become savvier with their choice of bank.
Deposit competition rising
According to APRA data, industry-wide deposit inflows have slowed this year, as households cope with rising costs by eating into their savings. As a result, competition for deposits has picked up. We expect the September half to be marked by the persistence of tighter deposit margins.
Mortgage competition rising
The Big 4 Banks’ management teams have all pointed to the intense competition in the mortgage market. As fixed loans continue to roll off over the next 6 months, we expect the competition for mortgages to remain elevated, which should put further pressure on NIMs over the next 6 months.
Slower Economy, Slower Volumes
As economic activity slows down, the demand for credit from households and businesses is likely to decline, leading to a period of below average lending growth. This would put further pressure on interest income.
Tightening credit conditions could further reduce interest income for banks. This tends to occur when the economic outlook becomes more uncertain. Banks may need to compete more aggressively to secure a smaller pool of creditworthy borrowers, putting further pressure on NIMs.
While we do not expect significant bad debt problems, banks will need to maintain higher levels of capital reserves to protect against potential losses from defaults and bad debts, which reduces profitability and lowers ROE (higher shareholder equity on the balance sheet).
Higher capital reserves also reduce the ability to distribute profits to shareholders in the form of dividends or share buybacks.
Lower ROE, Lower Multiples
Valuations may come under pressure as earnings face mounting headwinds. The price to book ratio (P/B) and ROE of banks tend to be correlated. A lower ROE should therefore lead to a lower P/B.
Consensus ROE is expected to fall over the next 12 months. With tighter-than-expected NIMs and higher capital reserves there is downside risk to consensus ROE and valuation multiples.
Costs Well Managed
Australian banks have demonstrated a noteworthy ability to manage cost pressures. The banks' recent results indicate they were able to effectively reduce their cost-to-income ratios during the latest reporting season, despite the challenging inflationary environment.
We believe that operating expenses are unlikely to pose a significant risk to the banks' earnings over the next 12 months, given management teams effective cost management strategies.
Preference to More Diversified Banks
We still have a preference to the mortgage-light banks ANZ and NAB over the mortgage-heavy WBC and CBA, due to the ongoing competitive intensity in mortgage lending. Given their greater exposure to business lending, we expect NAB and ANZ to experience less downgrades.
NAB is a high-quality bank that we believe can close the valuation gap on CBA over the next 12 months. CBA looks overvalued at a price to book of 2.1x relative to peers of 1.1x, and we cannot justify owning at the current premium.
| Company Name | Focus Portfolio Weight | Active Weight vs ASX 300 | 12 mth forward metrics | ISG Comment | |||
| Price to Book | Price to Earnings | Dividend Yield | ROE | ||||
| National Australia Bank (NAB) | 7.5% | 3.6% | 1.3 | 11.81 | 6.2% | 11.9% | NAB's 1H23 was a record result with Cash NPAT of $4.07bn (+12% HoH), although the trajectory of NAB's weighed on investors minds. After peaking in December 2022, the 1H23 NIM was 1.77%, which was worse than consensus expectations of 1.83%, reflective of the competitive environment for home loans and deposits. On the bright side, NAB's business banking segment (a key differentiating factor for NAB) protected its NIM from further compression (business bank NIM was up 27 bps HoH). |
| ANZ Group (ANZ) | 4.0% | 0.8% | 1.0 | 10.24 | 6.8% | 10.4% | ANZ's reported a record cash profit of $3.8bn in 1H23 (+13% QoQ) which was a ~0.4% beat to consensus. The key negative was 1H23 NIMs of 1.75%, which were below expectations of 1.83%, with management citing competition in the mortgage and deposits space. Positively, the institutional division provided a tailwind to NIMs and revenue growth, offseting weakness in its mortgage-related book to deliver an earnings beat. |
| Westpac Banking Corporation (WBC) | 4.0% | 0.5% | 1.0 | 10.52 | 6.7% | 10.1% | 1H23 result was better than expected overall with NPAT of $4bn beating consensus of $3.8bn. NIM was weaker than expected at 1.96% (vs consensus of 2.01%). WBC's exit NIM was 2 bps softer than the 1H23 average at 1.88%, reaffirming that intensifying competition continues to pressure margins. Offsetting NIM weakness was WBC's better than expected cost-out delivery, which saw the cost to income ratio falling to 45.3% (vs 57.9% the prior half). |
| Commonwealth Bank of Australia (CBA) | 0.0% | -7.4% | 2.2 | 16.39 | 4.6% | 12.9% | In its 3Q23 result, CBA’s Cash NPAT declined -2.9% QoQ to ~$2.6bn, having peaked in Q2. Net interest income fell -5% in Q3 vs Q2 as volume growth was offset by lower Net Interest Margins (NIMs) due to a continuation of ‘intense’ competitive pressure in home loans and deposits. |
Source: Refinitiv, Wilsons.
Written by
Rob Crookston, Equity Strategist
Rob is an experienced research analyst with a background in both equity strategy and macroeconomics. He has a strong knowledge of equity strategy, asset allocation, and financial and econometric modelling.
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