Nicholas Grove: The Morningstar equities research team recently released the Huntleys' Forecast 2013 sector reviews. Here to give investors an idea of what to expect from the banking and financials sector in the coming year, I am joined again by Morningstar sector head David Ellis.
David, thanks very much for your time today.
David Ellis: Thanks Nick, my pleasure.
Grove: First of all David, what are going to be the key macro issues, both domestic and international, that investors need to keep an eye on when it comes to this sector in 2013?
Ellis: Well, the key domestic macro issue is economic growth and the strength or lack of strength in Australian GDP for 2013 and even into 2014, as the massive mining investment boom is slowing down, and the concern is that it's slowing down faster. And when it reaches its peak, the pressure on the non-resource parts of the economy is expected to increase, and on the high Australian dollar and the flow-on effects of that combined with the federal government tightening their fiscal position. That means the GDP growth in 2013 will probably be slower than expected, and that will have a clear impact on the financial services sector, particularly the banks.
As far as internationally, the key things we're looking for internationally of course is, first of all, the US fiscal cliff negotiations are rapidly drawing to - hopefully - rapidly drawing to a close. If that goes badly, that will probably have a quite a significant negative impact globally on global equity markets, and conversely.
So, if there is some negotiation agreed between the two political parties in the US, well then that'll probably have a short-term positive impact on equity markets. Other global macro issues, of course, are the economic growth outcomes in China, and the flow-on effect for demand and price of commodities - particularly iron ore and coal which obviously impacts the Australian economy.
Grove: David, what do you expect from the big four banks in terms of earnings and dividends in the year ahead? And do you still expect a return of surplus bank capital to shareholders in the form of special dividends, buybacks or payout ratios in 2013?
Ellis: Yeah. Our position hasn't changed since the last time we spoke and that is for moderate credit growth, which will flow through to moderate revenue growth. There is an increasing focus and emphasis on improving the cost base of the banks. So, in relative terms, we'll see costs being reduced. And margins of course - net interest margins - are a major swing factor.
And over the last month or so, we've seen wholesale funding costs actually come down. Now, that has a longer, flow-on impact on net interest margins that's definitely not immediate by any stretch of the imagination. So, margins we expect will stay relatively stable. The big swing factor for bank earnings are bad debts, and that gets back to my first point or to your first question about he economy. If we see a sharp decline in the economy, an increase in unemployment, then we will see an increase in bad debts, particularly for business and commercial loan bad debts.
If we see a sharp increase in bad debts, well, then we'll see bank profits being under pressure. That's not our central case, that's not our main thesis. We expect the economy to muddle through and we wouldn't be surprised if bad debts do increase, but not materially.
And so, getting back to thesis or forward-looking thesis of capital returns or higher dividends, at this stage we're comfortable that the banks will continue to increase their capital base. They will have surplus capital, particularly Westpac, and probably CBA. And assuming the economy doesn't deteriorate sharply, then we expect to see capital returns to shareholders in the next 12 to 18 months and it may be in the form of special dividends or it could be share buybacks.
Grove: Stepping away from the banks for a minute, what sort of performance can we expect from the big insurers in 2013?
Ellis: Well, that's a tougher question. The insurers obviously are impacted by a lot of factors, not the least being the incidence of natural disasters and catastrophes. And in 2011 and 2012, we have seen a sharp increase in catastrophes around the world, which have impacted QBE severely, and to a lesser extent IAG and Suncorp.
Insurance premiums are increasing, which is a positive for profitability. There is better underwriting discipline. Reinsurance costs are going up, but we do expect to see a solid improvement in earnings for the three insurers, particularly QBE.
Grove: Finally David, how do you expect the wealth managers and the diversified financials to perform in 2013?
Ellis: Well, the wealth managers and the diversified financials are influenced heavily by equity market activity and strength, so they are leveraged to the markets. So, if we see a continued recovery in equity market values, well it'll do two things - one it'll increase the market value of funds under management, which will increase fee income for the wealth managers. But more importantly, we want to see a return of confidence from investors to start putting more money into the equity market, either directly or through managed funds. A lot of that money is currently seeking cash deposits with the banks.
So, if we see a recovery in confidence in the market, we will see a recovery in net flows into the listed wealth managers. We see a similar sort of outlook too for the property sector. Whilst a lot of the property stocks have run quite hard over the last six months, the last 12 months, we're pretty confident in underlying asset values, property values, and we expect further investor demand for those higher-yielding, quality, income-producing property trusts.
Grove: David, thanks very much for your time today.
Ellis: It's a pleasure, Nick.