Buy Hold Sell

Buy Hold Sell: How bad will the fixed-rate mortgage cliff be (and 2 stocks that could still benefit)

Fri 07 Jul 23, 9:45am (AEST)
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Source: Livewire Markets

Key Points

  • The fixed rate mortgage cliff is not as big of a deal as it sounds. Only about 5-6% of Australian adult households will have their mortgage reset this year
  • Banks are well-prepared for a recession, but investors should still be cautious
  • Insurance companies are benefiting from rising interest rates

Much has been made of the pending mortgage cliff, and fair enough. The RBA cash rate has gone from the pandemic low of 0.1% to 4.10% in a little over a year, and the central bank estimates half of all fixed rate loans that enjoyed that 4% buffer will expire this year.

Whilst that sounds ominous, there are some things to remember. Only about one-third of Aussie adults have a mortgage (the rest being owners or renters) and at the peak in 2021, only about 35% of mortgages were fixed rate.

Whilst half of the 35% will expire and face a mortgage cliff this year, many Aussies who own outright or rent, won’t be affected at all.

So, are the banks really in that bad a position? And what about companies that actually benefit from higher interest rates, like the insurers?

As always, tarring any sector with the same brush is pointless and thankfully we have Andrew Martin from Alphinity Investment Management and Michael Maughan from Tyndall Asset Management to help sort the financial wheat from the chaff. 

Note: This episode was filmed on Wednesday 28 June 2023 and first published for Livewire Markets. You can watch the video, listen to the podcast, or read an edited transcript below.

Edited Transcript 

Ally Selby: Hey, how you doing? And welcome to Livewire's Buy Hold Sell. I'm Ally Selby, and over the past six months, investors have been completely bombarded with countless articles on the fixed rate mortgage cliff and the outlook for the big four banks. So today we're taking a deep-dive into financials, and we'll also learn fundie's topics picks within the sector. So today we're joined by Andrew Martin from Alphinity and Michael Maughan from Tyndall.

The fixed-rate mortgage cliff

Okay, Andrew, I'm going to start with you today. Everyone's talking about this fixed rate mortgage cliff. What do you see its effect being on the economy?

Andrew Martin: Thanks, Ally. Look, I think if you're getting a mortgage reset, it probably feels like a cliff, but from an economic point of view, it's probably more like a mortgage hill - to be honest. About a third of Australian adults have a mortgage, another third own their own home, and another third have neither. Typically, 15 to 20% are fixed rate mortgages, but at the peak in '21 it got to 35% of mortgages, and about 50% of those are actually maturing or refinancing this year. So if you work that through, it actually works out to only about 5-6% of Australian adult households having a mortgage reset this year. To me, the bigger issue is actually the people who didn't have a fixed rate mortgage. It's those who had a variable rate mortgage for the last year when rates have been rising rapidly. And it's that cumulative effect of those people that have been dealing with that already, that is really what's slowing the economy down and why we're hearing more anecdotes about a slowdown in retail spending, for example.

Ally Selby: Do you agree, Michael?

Michael Maughan: Yeah, I think what's interesting is the RBA probably paused in April because there was uncertainty about how this big step up for these borrowers was going to impact the market. And I think that's probably what drove the increasing competition for the banks in the last quarter. We had CBA coming out very aggressively back in February. And by May, they're saying the war's over in terms of bank competition, we're going to pull back on cashbacks. So I think that uncertainty and people not knowing exactly how that was going to play out created some short-term noise in the market.

What about credit quality?

Ally Selby: Credit quality has actually been better than expected. As the economy slows, if it does, what will that mean for profits and dividends?

Michael Maughan: No one's expecting bank bad debts to be this low going forward. The normal levels of bad debts are higher than where we are now, and everyone's forecasting that, and banks are provisioned for that. So it shouldn't really affect the bottom line too much in terms of the profits of the banks. Where banks get hit at a point like this is on the rating. So the PE gets affected by the fact that the market's looking forward at a potential recession and shoots first.

Ally Selby: What do you think?

Andrew Martin: I agree with that. We’ve just got to remember that the central bank is actually trying to slow the economy down. And the only way they can do that is by putting rates up, which ultimately leads to more unemployment. When you get unemployment, that's when you get the credit issues. The main issue at the moment is that's been pushed out. Everyone was expecting it this year, but all the excess savings and the fact that everyone's employed has meant that those issues have been pushed out. So it's probably more like next year we're thinking about, but banks are really well-prepared for a downturn.

Invest in bank shares or have your money in the bank?

Ally Selby: For years it's been better to invest in bank shares than to have your money in the bank. Do you think that's changed now?

Andrew Martin: I think it's more line-ball. With interest rates going up and the banks competing for deposits, you can get term deposit rates now 4.5- 5%, which is pretty attractive. We haven't seen that for a long, long time in Australia. You compare that to bank dividend yields of about 5.5-6%, depending on the bank, which is pretty attractive. Add on franking, that's in the eights. So it's still pretty attractive to get a bank dividend yield. The difference is you don't lose your capital in a term deposit, but you might if you buy a bank. And as Michael was saying, at this point in the cycle, it is more risky for bank share prices, therefore it probably makes it a bit more line-ball.

Ally Selby: What do you think, Michael? As interest rates rise, is cash really trash?

Michael Maughan: I think there are a couple of key points there. Andrew mentioned one of them, which is the franking on bank dividends. That's a really important differentiator. If you look at the CBA yield, it's probably not that dissimilar to what you can get on deposit, but you add the franking and it's substantially above. The ANZ dividends are probably more like 10% against a 5% deposit rate. And the other thing is inflation. We're talking about 5% being a good rate. It's still a negative real yield. So I think we've got to look at these numbers. We get a bit caught up in the absolutes. It used to be 1%, now it's 5%. Isn't that a lot better? Well, kind of.

Which financials?

Ally Selby: Is there any part of this sector that has really benefited from this new market environment?

Michael Maughan: As a rule, financials all benefit from rising rates, but insurance is the one in particular that's benefiting at the moment. If you think about the cash that they hold to pay claims, finally getting a decent return on that after a long time of getting very little. And if we think about an industry like that and whether it's able to sustain the profits that it's generating from that, it comes down to the intensity of competition. And it feels like there's a reasonably benign degree of competition in the insurance market at the moment, and that's why we have confidence that that can be maintained.

Ally Selby: How sustainable do you think those returns will be for the insurers?

Andrew Martin: I think the important thing is that unlike other rate-sensitive parts of the market, like banks for example, where they've chosen to compete away the benefit, the insurers aren't competing it away, and so you're getting these premium rate increases. And the way that earnings work for insurers, that flows through over a number of years. So this can be sustained at least for another year, if not longer.

Insurance Australia Group (ASX: IAG)

Ally Selby: Okay. Let's get into buy, hold, sell. First up, we have Insurance Australia Group. Andrew, I'll start with you. Is it a buy, hold or sell?

Andrew Martin (HOLD): It's a hold for us. We do like the insurance sector. We like the fact that premium rates are going up. They benefit from interest rates going up as well, but it is the premium-rated stock in the sector. We think you can get the same exposure elsewhere at a much cheaper price. So it's a hold for us.

Ally Selby: Okay. Its share price is up over 30% over the past year. Michael, is it a buy, hold or sell?

Michael Maughan (BUY): IAG is a buy for us. I don't disagree with what Andrew's saying, but we think the rising tide lifts all boats in this environment and all the insurers are buys, even though IAG is not our preferred stock in the sector either.

ANZ Group Holdings (ASX: ANZ)

Ally Selby: Okay. Next up we have ANZ Group. Is it a buy, hold or sell?

Michael Maughan (BUY): ANZ's a buy. As we said before, banks do well in rising rate environments. The risk is to the rating when we go through recessionary times, and that's already in the price with ANZ. ANZ's trading on a 10 times PE, the market's on 15 times, and CBA's on 17 times. So we think that it's a price for its reality.

Ally Selby: Okay. Its share price is up around 5% over the past 12 months. Andrew, is that one a buy, hold or sell for you?

Andrew Martin (SELL): ANZ's a sell for us. We have a bit of a negative tack on banks overall at this point in the cycle, but with ANZ, we're not a big fan of their retail strategy. Building a whole new bank on the side, then trying to transfer everyone across. We think it's risky and unproven, and the CEO won't even be there to see it through. Biggest exposure to New Zealand, who we are a bit concerned about as they head into recession, issues with costs, it's a sell for us.

Netwealth (ASX: NWL)

Ally Selby: Okay. Next up we have wealth management platform provider, Netwealth. Andrew, last one for you. Is that a buy, hold or sell?

Andrew Martin (SELL): That's a sell for us. It's a company we like, i.e., the business and the management team. It's just at a far too ritzy valuation for us, at 40x earnings. They had a golden run there for a bit where all their competitors were in disarray. The banks, AMP, IOOF. They're all back in the game now. Technology's improved. And for a company like Netwealth at 40x, you can't have your top line grow slowing. So we're concerned about that, so sell.

Ally Selby: Its share price has lifted around 30% over the past year. Michael, over to you. Is it a buy, hold or sell?

Michael Maughan (HOLD): Netwealth is a hold for us. I agree with what Andrew's saying. I mean, they've benefited from the banks getting out of wealth and that helped their flows, but we're still expecting 15-20% revenue growth from that company. Yes, it's too expensive to buy more here, but it's still a very, very good company.

Ally Selby: We asked our guests to bring along their highest conviction pick within the financial sector today. Michael, I'll start with you. What have you brought for us?

QBE Insurance (ASX: QBE)

Michael Maughan: We think the most compelling stock in the financial space is QBE. If you look at the investment returns picking up, the premium growth is much higher than costs. So all of those are the positives that we know about for insurers. This one, in addition, trades on a much lower rating, partly because of some of the history, and there's a new management team and we think there's an opportunity for the 30% discount that QBE trades at to IAG, for example, to narrow.

Ally Selby: Okay. Over to you, Andrew. What have you brought for us today?

Medibank Private (ASX: MPL)

Andrew Martin: We actually agree with Michael. There's not too many places in the market where you get earnings upside and good valuation. So we like QBE as well. But we think, in your portfolio, you need something defensive at this point in the cycle. And so for us, that's Medibank. It's the private health insurer. Different part of insurance, still benefits from interest rates going up. Obviously been in the headlines for all the wrong reasons recently about the cyber hack, but that gives us an opportunity. And underlying the business has moved past that now, growing customer numbers again, dealing with costs well, so you get the leverage, completely transformed how claims are being dealt with in Australia. But the cherry on top, if you like, is a completely ungeared balance sheet. They have no debt coming into this era of higher rates. It allows them to do acquisitions. And if they can't find the acquisitions, then they can do capital management. So it's the bedrock of your portfolio in a defensive sense. So it's a buy for us.

Ally Selby: What more could do you want? Well, I hope you enjoyed that episode of Buy Hold Sell as much as I did. If you did, why not give it a like? Remember to subscribe to our YouTube channel. We're adding so much great content every single week.

Written By

Buy Hold Sell

Buy Hold Sell is a regular video series where Australia's leading professional investors share their views on Australian and Global Shares. This content is produced by Livewire Markets and has been syndicated to the Market Index website.

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