Are there reasons to be cheerful about banks? The sector is awash with cash as lending opportunities have been reduced during the pandemic and interest rates remain stubbornly low. Excess liquidity is also reflecting the regulatory issues plaguing the banks, which have made large provisions in balance sheets over recent years. How can the banks re-rate in this climate?
Citi and Goldman Sachs note some positive signs for banks, although differ in the means and timing of a recovery, while Macquarie is negative, suspecting that, despite lower impairment charges, capital management potential and promises of cost efficiencies, banks are unlikely to experience further re-rating of share prices.
The reason for being overweight banks is increasingly driven by the macro environment and current lockdowns suggest a near-term risk to the sector performance. Hence, Macquarie expects, with the extent and duration of the latest lockdown in Sydney and other states unknown, the outlook is very uncertain.
Material losses are not expected to eventuate but there is still a risk. Also, falling bond yields will drive margin pressures. The broker maintains a preference for regional banks over majors and National Australia Bank ((NAB)) and ANZ Bank ((ANZ)) over Commonwealth Bank ((CBA)) and Westpac ((WBC)).
The risk to market income, one of the main volatile items in bank results, appears skewed to the downside, the broker asserts. Using US investment bank quarterly results, Macquarie notes weaker trends offshore signal potential downside risk for the Australian majors.
Admittedly, Australian banks, in terms of markets and trading income, do differ from US banks as a more significant proportion of revenue comes from interest rates and foreign exchange. On the broker’s analysis ANZ appears to be more leveraged to the trends observed from offshore peers, because of a larger global markets business.
NAB and Westpac are less correlated in this way while CBA market income only has a slight correlation to offshore peers, partly because of disclosure differences.
Buybacks?
Morgan Stanley believes the buyback announcement from ANZ suggests APRA (Australian Prudential Regulatory Authority) is comfortable with current CET1 ratios and anticipates a buyback by CBA in August although Westpac and NAB are likely to “wait-and-see”.
The broker acknowledges the current lockdowns have provided potential for buybacks to be delayed or reduced but ascertains CBA could undertake an off-market buyback to the tune of $5bn and still maintain an ex-dividend CET1 ratio of 12%.
Moreover, Morgan Stanley calculates NAB, given indications APRA is comfortable with a August 2021 minimum CET1 ratio of around 11.7%, has around $2.5bn in capacity and Westpac around $2.4bn.
That said, Morgan Stanley does not expect buybacks from either as soon as August, forecasting Westpac will eventually announce a $3.5bn off market buyback and NAB commence with a $4bn on-market buyback with its first half results in May 2022.
The size of any buyback from NAB is also likely to be influenced by the outcome of its discussion with Citigroup about potential acquisition of its Australian consumer business.
Inflation/Rates
Despite concerns about rising inflation, interest rates have actually declined in recent weeks, something quite unexpected. Citi assesses weak rates have been an obstacle for bank sector performance, despite some improving fundamentals such as stronger mortgage credit growth and the lowest personal insolvencies in a decade.
Balance sheets from the banks provide some insight into why low rates are persisting. Significant excess liquidity has not found a home fast enough. Lending will eventually improve and the excess clear, providing leverage to the US ten-year yield if inflation persists in the short term. The broker considers Westpac is best placed, being differentiated enough to expand returns while extracting costs.
While the domestic banking system has accumulated around $240bn of excess funding since the onset of the pandemic, through deposit growth and a lack of lending opportunities, mortgage credit growth has now picked up as deposit growth begins to slow and this should mean excess liquidity gets used up, eventually.
Citi estimates it will take, on average, around 20 months for excess funding to be run down on the balance sheets of major banks and the vast majority of funds will go into the mortgage market.
Yet despite green shoots in mortgages, excess liquidity continues to be an obstacle. The Delta outbreak in Sydney and Melbourne for any extended period will not help, although the broker points out the pandemic remains a global issue irrespective of the Australian lockdowns.
In turn, this has implications for when cash rates will rise and dictates the steepness of the yield curve. Hence, deposit margin-led profit growth for banks can improve share price performances but – and this is the crunch – it will not happen soon.
Business Investment
Business investment may be weak at this juncture, yet Goldman Sachs highlights another positive aspect to the outlook for banks: commercial lending in 2022. The broker’s business credit lead indicators suggest the outlook for domestic business credit growth will improve over the next year and there is further upside risk towards the end of 2022.
Goldman Sachs forecasts system business credit growth to recover to 4.5% by September 2022 and NAB is the most exposed, with 32% of total loans and a small-medium enterprise bias.
The current mix of business investment is boding well for commercial loan growth and a strong rebound in non-mining investment has accounted for most of the capital expenditure recovery, the broker suggests.
In particular, this stems from the temporary but full expensing of investment scheme borrowings, which pulls forward equipment expenditure. There is also evidence that capacity constraints and pandemic-induced structural changes have generated demand for new investment in retail and transport.
Goldman Sachs prefers NAB as it provides the best exposure to a commercial lending recovery. Furthermore, the purchase of property for a business shows the strongest correlation with business credit growth when lagged by 12 months.
Growth in commercial lending approvals has shown signs of reaching an inflection point in the second half of 2021. Translating the data, Goldman Sachs expects momentum will pick up slightly in the second half, amid tailwinds such the roll-out of the covid-19 vaccine and high levels of bank liquidity.
Investor Shift
Share registries of the banks are also shifting further towards domestic institutional investors while retail investors and offshore investors have reduced positions in the banks.
Macquarie was surprised by the retail selling, given bank dividends remain attractive in a low interest rate environment and noting domestic institutional investors continue to build positions in the banks, with NAB retaining the largest active position.
In the broker’s assessment of active positions by retail investors, relatively they are overweight CBA, marginally overweight Westpac, and underweight ANZ and NAB.
Retail investors were net sellers in the second quarter of 2021, consistently across all banks. On a relative basis compared with the broader market, the broker acknowledges banks look cheap as, besides CBA, they are trading at a -40% discount to the five-year average of -33%.
