Higher margins to drive earnings despite headwinds

Credit growth has eased as higher interest rates and inflation reduce borrower capacity. Total growth slowed to an annualized 4.7% in the last three months and to 4.0% for housing, which makes up two-thirds of loans. We expect low-single-digit medium-term credit growth.

Our expectation of low credit growth is consistent with Reserve Bank of Australia forecasts for gross domestic product growth to average around 1.9% in fiscal 2024 and 2025. Rising house prices and drawdowns of savings add to total credit growth.

Exhibit 1

Net interest margins are softening because of competition in loan and customer deposit rates. Repayment of cheap Reserve Bank of Australia funding and higher refinancing levels are elevating competition. When banks had a back book of loans on much higher rates, cheaper loans to new customers could still deliver the bank strong returns overall. However, the difference in the average rate for new and existing loans has closed materially. We expect loan rates offered by banks will gradually increase to prevent return on equity from sliding below the cost of equity.

Exhibit 2

Loan loss risk is still elevated as borrowers face a material increase in interest payments. However, current arrears are below 2019 levels, borrowers have larger equity buffers, and banks hold extra bad debt provisions. Most borrowers have been able to cut discretionary spending to meet repayments where necessary. We gain significant comfort that loans were made with a 3% serviceability buffer, labor and rental markets are tight, and housing demand is spurring house price growth. Expired fixed-rate loans are performing in line with the rest of the home loan book.

Exhibit 3

Major banks are fairly valued, nonmajors cheap

The weighted average price/fair value estimate of the major banks is 1.05, up from 0.97 in the last quarter. Nonmajor banks trade at a price/fair value of 0.85. Nonmajor bank net interest margins are squeezed by intense deposit and mortgage rate competition, but we expect an improvement as wide-moat major banks seek to improve returns.

Exhibit 4

Even after paying final dividends, on an average weighted basis, major bank share prices increased 7.9% in fourth quarter 2023 and 5.6% over the last 12 months. We see value in Westpac and ANZ Group. For Westpac, we think the share price overlooks the potential for the bank to lower its cost/income ratio and improve ROE, relative to peers.

Exhibit 5

Opportunities remain as competition is likely to abate

Westpac and ANZ Group are cheap: Both banks have addressed market concerns around lackluster loan growth, and the next catalyst will be the delivery of operating efficiency improvements.

Commonwealth Bank is expensive: On a forward P/E of almost 20 times and a fully franked dividend yield of just 4%, valuation metrics are stretched and leave little room for disappointment.

MyState is the cheapest: A higher risk proposition because of a weak competitive position, but industrywide loan and deposit repricing will support earnings growth. Loan growth and cost-efficiency gains are also expected.

Exhibit 6

Dividend yields are attractive despite higher deposit rates

The divergence in valuation between Commonwealth Bank and peers Westpac and ANZ Bank is stark, and in our view, unjustified. Price/book discounts are likely to unwind as Westpac and ANZ Bank hold market share and deliver earnings growth.

Exhibit 7

After resetting payout ratios, dividends can now grow in line with earnings. Share price weakness in most nonmajor banks has pushed dividend yields to attractive levels. Nonmajors have less cheap customer deposit funding, but the margin downside risk is now more than reflected in stock prices.

Exhibit 8

 

Top Picks

Turnaround stories Westpac and ANZ Group are Top Picks; MyState cheap as market overstates margin downside

Westpac Banking Corp

As the second-largest lender in Australia, we remain confident the funding cost advantages wide-moat-rated Westpac (ASX:WBC) enjoys will see a return to strong profits and returns on equity over time. Customer remediation, uplifting risk management and digital investment, and divesting nonbank businesses were costly and distracting. Not only did operating expenses rise as revenue was under pressure, but loan approval times were slow. Loan approval times (and loan growth) have already improved, but a rebasing of costs will take time. We think Westpac can maintain a dividend payout ratio of 70% which underpins an attractive fully franked dividend yield. The balance sheet is sound.

ANZ Group Holdings

ANZ Bank (ASX:ANZ) has lost material home loan market share, and having less funding sourced from low-cost household customer deposits has incurred material margin pressure across the bank. Process investments should make the wide-moat bank more competitive in home lending. While this comes with added operating expenses, it should help drive earnings growth and returns on equity. Suncorp Bank is expected to improve bank efficiency, but the acquisition and integration costs make it unlikely to be materially value-accretive.

MyState Ltd

MyState Bank (ASX:MYS) commands a tiny 0.3% share of the Australian home loan market, but with investment in its digital offerings and expanded sales team, has demonstrated an ability to profitably grow loans. We expect market share gains to be more difficult, with cost inflation and rising wholesale funding costs affecting smaller banks more than major banks. While MyState margins will likely fall more than major banks due to rising customer deposit funding, due to a greater reliance on term deposits, it is still better placed relative to nonbank lenders. MyState focuses on lower-risk owner-occupier borrowers with a loan/value ratio below 80%.

Bank of Queensland

We expect Bank of Queensland's (ASX:BOQ) medium-term earnings recovery to be driven by net interest margin improvement as industry competitive pressures ease and the bank extracts cost savings from consolidating banking platforms and digitizing more processes. Bad debts are almost certain to rise, but we take comfort that recent loan growth has not been driven by compromised lending standards. Increased exposure to home loans outside of Queensland is also helping to diversify risk. Our long-term bad debt/loans forecast of 12.5 basis points is below the 10-year average of 16.0 basis points, driven by changes in the mix of loans.