Which banks? 6 brokers and a fundie answer the question

This piece was first published on Livewire Markets on Monday October 3 2022.

Australia’s banks are often regarded as relatively resilient to interest rate rises. But in a market and economic environment that has defied various definitions of “normal” does this still hold true? In this feature, I consider how a few brokers are looking at the sector and speak to a fund manager for their take.

Goldman Sachs

The last time the cash rate hovered around 3%, back in 2013, the returns on tangible equity (RoTE) for Australian banks was around 19%, say Goldman Sachs analysts Andrew Lyons and John Li in a research note issued on Wednesday.

A couple of things should be unpacked here: RoTE compares profits generated for equity investors with the level of equity capital, excluding capital assets. It’s commonly used when analysing banks and insurance companies. And as a comparison, this 19% RoTE was 9% higher than in FY2021, when the cash rate was just 0.1%.

What’s behind banks’ profitability declines? 

Lyons and Li point to four things:

1. Regulatory pressures – to which they attribute around 6% of the 9% deterioration in RoTE during this period. The remainder came from higher capital and liquidity requirements.

2. A lower returning product mix – which drove around 3% of the profitability falls, including banks’ exit from wealth management

3. Large one-off items in FY2021, which contributed around 1% of the decline, and

4. Bad and doubtful debts, which drove around 2% of the profit fall.

What does this mean?

On balance, they regard like-for-like returns as only 1% below their 2013 level.

We think the banks have done a good job of defending profitability in the face of much lower rates, albeit there should be the opportunity for profitability to rise as well,” said Lyons and Li.

At the company level, they cite Commonwealth Bank (ASX: CBA) as the best defender of profitability since FY2013. And Westpac Bank (ASX:WBC) was the worst over the period.

So, why do they rate Westpac a Buy?

It comes down to their view on net interest margins (NIM), which is a metric that reveals how much a bank is earning in interest on loans compared to the amount it is paying in interest on deposits. The Goldmans analysts have a higher conviction on NIMs as the cash rate closes in on 3% - as is currently occurring. They expect NIMs to rise 1.9% in FY2024, which would bring them in line with their 2013 level.

This means they’re currently between 0.3% and 0.9% ahead of consensus forecasts for FY2024 NIM, which would drive RoTEs of between 12% and 13%.

“Therefore, with the sector trading on 1.6 times spot price versus net tangible assets, we think value exists,” say Lyons and Li.

Westpac (ASX: WBC) is Goldman's pick of the sector

They give four reasons for this:

• Its performance is strongly leveraged to a rising interest rate

• Superior cost management

• The bank’s latest market update indicating ongoing investment in the business

• Supportive share price valuations.

This differs from Goldman Sachs’ view before the August earnings season, when National Australia Bank (ASX: NAB) and ANZ Bank (ASX: ANZ) were their top picks. They highlighted six key indicators ahead of this period: margins, capital, bad debts, expenses, volumes and markets.

And contrasting with their view now, their outlook was for lower NIMs, driven by tighter competition.

Westpac's six month charts as at Tuesday 17 January 2023 show how performance has travelled since Goldman Sachs made its call in October last year

What do other brokers think of Aussie banks?

• UBS’s latest note on banks emphasises forward PEs of around 99% versus a five-year average of around 80%. UBS downgraded Australian banks to Neutral, from a previous rating of Overweight.

• Credit Suisse is closely watching net interest margins and cost inflation across the sector. Expected NAB to deliver the best overall result, and ANZ to be the weakest result.

• Morgans has shifted to a more cautious stance, with NAB its preferred bank. Across the board, it regarded NIM tailwinds from rising rates to be partly offset by drawdowns from the Term Funding Facility. The broker also says rate hikes will reduce credit growth and increase the risk of asset quality deteriorating.

• Jarden says banks are trading at fair value, regarding positive tailwinds from rising rates as already baked into share prices. Its key pick is NAB, with ANZ the best value pick of the group.

• JP Morgan also cites NAB as the pick of the local cohort due to its revenue growth and an expectation of only modest cost increases.

What are the big 4 banks worth?

Brad Potter, head of Australian equities at Tyndall Asset Management, believes the market is struggling with “cognitive dissonance” in deciding the answer to this question.

“They’re trying to price in inflation and the rising interest rate environment, at the same time as pricing in a recession and falling rates,” he says.

“And related to that, the market’s trying to work out the NIM margin expansion that will definitely come through, but at the same time, the probability of a recession in 2023 or maybe even 2024, which is holding back banks’ share prices.”

Potter expects the major bank NIMs will continue to increase strongly over the next six to 12 months, which will be positive for their earnings during this period before margins then begin to roll off.

“But it will probably stay higher than it was prior to this cycle, so there’s going to be decent earnings growth,” he says.

The most important signals

From an individual company perspective, NIM is the metric Potter’s team is watching most closely because it is a more powerful driver of the banks’ earnings than the growth of their credit books.

“But the other big question is are we going to see an increase in bad debts?” he says.

“I don’t see any signs of that currently, and from a mortgage perspective, we need a substantial increase in unemployment to see that in any material way.”

This is why the labour market is a key indicator of how bank share prices are expected to perform.

“The projection from many is that unemployment might rise by 1% – we probably need 7-8% unemployment levels to really make an impact and that’s hard to envision when we’re sitting at 3.5% unemployment now, combined with the labour shortages we’re seeing,” Potter says.

Facts versus feelings

The delicate balancing of business and economic fundamentals alongside investor sentiment is another key consideration. This is especially true against the looming prospect of a recession.

“In a recession, I don’t think the banks will be impacted particularly badly, particularly given their very strong balance sheets, capital liquidity and provisioning levels,” Potter says.

“But from a sentiment perspective, banks get sold off during a recession. And that’s why, despite the fact we’ll get decent earnings growth coming through in the next six to 12 months, their share prices are probably not reacting very well."

How Tyndall is positioned

Each of the four major banks is held in the wholesale-focused Tyndall Australian Share fund. Its two biggest positions in the sector are Westpac and ANZ Bank - with overweight allocations of 5.5% and 5.3% – followed by National Australia Bank, on which it is neutral (4.5%). The fund has an underweight allocation to Commonwealth Bank, which sits outside its top 10 holdings.

“CBA arguably deserves to trade at a premium to the other three banks, but the premium it’s trading on is astronomical,” Potter says.

Commonwealth Bank's six month charts show how performance has fared since this article was first published on Monday 3 October 2022