The biggest story for Australia's bank stocks

This article was first published for Livewire Markets on Wednesday, 15 March.

The fundamentals of local bank margins and earnings – not panicking about the collapse of SVB, even though it is a major occurrence – should be top of mind for financial sector investors currently.

That's according to Matthew Davison, portfolio manager at Martin Currie Australia, who touched only briefly on the events that unfolded at Silicon Valley Bank in recent days, during an interview on Tuesday afternoon.

Local bank stocks are down between 1.9% and 4.3% since the market opened on Monday 13 March.

ASX "Big 4" share prices

12-month daily share prices for ANZ (blue), CBA (yellow), NAB (red) and Westpac (green) from TradingView

“It’s been quite a muted reaction locally, compared to what we’ve seen in other markets, helped by the fact the resolution came through on Monday morning,” says Davison.

More to the point, he says investors are still digesting the pressure on wholesale funding markets, which is a medium-term factor in the outlook for Australian banks on margins and earnings.

Since Davison last wrote about the banks back in January, he notes the big four have delivered strong pre-provisioning updates.

“But we’ve had additional evidence that headwinds to margins are building, and clearly the next leg in mortgage competition, as banks fight for refinancing customers – that’s got the market focused on the peak in margins,” he says.

“And it occurs through 2023, where there’s certainly evidence that we’re close to the peak of net interest margins for banks.”

Through the half-yearly reporting season, when CBA announced record profits - banks have had a very good earnings story and surprisingly strong asset quality.

“But going forward, the earnings story becomes a bit weaker,” says Davison.

Tailwinds all blown out for Australia’s big four

The above comments align with the view outlined in a recent update from investment bank Morgan Stanley, which says the outlook for Australia’s big four banks has dimmed and the earnings upgrade cycle of the last 12 months has run its course.

There were headwinds aplenty called out in the investment bank’s recently released banking sector update. The all-important net interest margin is expected to peak earlier than previously thought and at a lower level, as all four face declines throughout 2023 and into 2024.

This margin decline is exacerbated by tighter competition in the lower interest rate environment. The Morgan Stanley equity analysts – Richard E. Wiles, Sally Hong, Charlie Hall, Andrei Standnik, and Sally Zhou – expect the average margin of the big four to increase around 17 basis points in FY2023 but see a fall of around 8 basis points in FY2024.

“Key headwinds include ongoing home loan discounting and refinancing, mortgage cash-back and broker commissions, increasing deposit competition, an unfavourable mix shift, and Term Funding Facility (TFF) maturities,” write the analysts in the Morgan Stanley update, which is ominously titled, No More Tailwinds.

The prospects of loan growth aren’t likely to improve in 2023 or 2024, as the strong business loan and housing loan growth of 2022 rolls off. Downward pressures here are driven by a combination of:

• The economic slowdown

• Ongoing rate hikes

• Falling house prices

• Higher mortgage serviceability hurdles.

Costs are still high across major banks, with only Westpac pursuing a meaningful shift in its approach via a “Cost Reset” initiative. Morgan Stanley expects average expense growth of around 5% across the big four banks in FY2023.

Loan losses are also tipped to rise, even given Morgan Stanley’s base case for a soft landing in Australia. The investment bank sees double-digit earnings headwinds in each of the next two financial years, with forecast loss rates of 16 basis points and 29 basis points in FY2023 and FY2024.

Unsurprisingly, dividend payout ratios are also expected to remain static and large buybacks look unlikely.

Westpac Banking (ASX: WBC)

Rating: Overweight

Price Target: $23.70

Morgan Stanley is positive on Westpac’s expanding margins in FY23 in response to higher rates and the steeper yield curve. The broker also emphasises the bank’s:

• focus on improving franchise performance,

• cost reductions,

• lower risk profile relative to peers,

• recovery of earnings and return on equity,

• lower investor expectations.

But challenges include the need for strong execution, the difficult economic environment and the impact of higher inflation on costs.

Westpac’s share price closed at $21.23 on Tuesday 14 March.

ANZ Group (ASX: ANZ)

Rating: Equal-Weight

Price Target: $26.20

Morgan Stanley rates ANZ Bank, which is the most internationally-focused of the big four, as Equal-Weight, with a price target of $26.20

With the lowest exposure to mortgages among its big bank peers, Morgan Stanley also highlights its currently trading at a discounted PE multiple - as discussed below.

But on the downside, the team also points to challenges, including:

• Margin headwinds

• Higher cost growth

• Potential for some nasty surprises, including acquisition risks and management changes

• Weaker economic outlook, including from its New Zealand exposure.

ANZ shares closed at $22.99 on Tuesday 14 March.

Commonwealth Bank (ASX: CBA)

Rating: Underweight

Price Target: $85

Key considerations underpinning this view include:

• High PE multiple, despite lower growth and the higher interest rate environment

• Elevated investor expectations, and

• An outlook for slower earnings into FY2024.

But on the upside, Morgan Stanley points to the bank’s strong track record, well-positioned digital banking business, solid capital position, and sustainable payout ratio.

The CBA share price closed at $94.63 on Tuesday 14 March.

National Australia Bank (ASX: NAB)

Rating: Equal-Weight

Price Target: $30

The broker cites the bank’s improving return on equity, good recent operating performance and margins, and healthy provisioning. It is also buoyed by the bank’s ongoing $2.5 billion buyback.

On the downside, Morgan Stanley calls out elevated investor expectations, slowing loan growth outlook for FY2023 and higher costs ahead. It also cites NAB’s business mix, which leaves it more exposed than peers, and full trading multiples.

NAB shares closed at $28.03 on Tuesday 14 March.

The fundie's view

Asked whether he believes share prices have peaked for Australia’s biggest banks, Martin Currie’s Davison says they each need to be weighed individually. He believes Commonwealth Bank is the most likely to see substantial share price falls.

“It hit a really high valuation globally, on the back of a particularly strong earnings story that has shown signs of peaking. The market’s not willing to pay that premium.”

On the other hand, he likes ANZ Banking Group because:

• it’s less exposed to mortgage profitability,

• has a window to refinance some of its lending book, and

• maintains a strong commercial banking business with reasonable margins.

“It’s not necessarily the peak in share prices for all banks,” says Davison.

What are the big swing factors now?

Loan losses will rise, but this won’t happen all at once and won’t necessarily be as severe as some in the market expect.

“We’ve still got a good job market, corporate customers that are showing quite healthy signs,” says Davison.

Falling house prices alone won’t trigger a huge impact on bad debts – for that, you’d need to see that confluence of worsening employment, worsening corporate health and the stressed consumer segment to see a decent jump in loan losses.

“Loan losses are a headwind but they’re not material at this point. It’s more about revenue growth peaking, that’s the big driver of the sector.”

Which banks are best placed?

For the reasons mentioned above – a valuation discount, lower exposure to mortgages, and profitable commercial banking business – ANZ is Davison’s pick of the local banks.

And outside of the big four, he also likes Bendigo Bank (ASX: BEN) where the NIM story beat the consensus outlook. “They can probably persist at stronger levels for longer than some peers, given its sticky deposit base,” says Davison.

“We also still like Virgin Money UK (ASX: VUK) but that really reflects a need for a re-rating. We think the management of the business going well and the stock has unfairly de-rated, with all the UK banks trading at quite heavily discounted multiples.”