The outlook for the big four banks

Higher cash rates will continue to support solid earnings growth for the big four, according to Morningstar bank analyst Nathan Zaia.

It is an assessment he had already made in 2022. The big four banks had reported increased margins in their fiscal 2022 results, underpinned by rising interest rates.

Fast forward to January 2023 and in Morningstar’s Q1 2023 outlook - available to Investor subscribers - Zaia also expects banks to price loans and deposits that will support margin growth and even provide them with low double-digit return on equity.

Better bank margins are even expected this year, despite intense competition - and here is where the big banks will have the upper hand.

“Customer deposits are a large part of margin expansion. On average, transaction account balances make up 40% of major bank deposits, a cheap source of funding that will aid expansion of net interest margins,” Zaia said.

Indeed, banks will continue to pass the rate increases on in full to borrowers while keeping rates lower for customer deposits.

Zaia also expects credit growth to slow, particularly as higher interest rates and inflation curtail borrower capacity. The rate hikes so far have already shaved more than a quarter off the maximum borrowing power for a typical borrower. 

Mortgage stress to rise

Falling house prices will also hit investor confidence and another emerging challenge for the banks is the prospect of higher loan losses.

As we enter the new year, after eight rate hikes, credit stress certainly does remain a challenge.

However, the discipline around capital management during Covid-19 has positioned banks for a better outlook amid these economic challenges.

In a recent client note, Zaia provided a detailed assessment of how banks will be positioned in 2023 amid concerns about mortgage stress.

“Credit stress isn’t evident yet,” Zaia said. “The reversal of COVID-19 provisions meant that the major banks reported historically low bad debt expenses in fiscal 2022.”

Acknowledging that there is a lag between the increased cash rate by the central bank and that increase being passed onto borrowers, it is tricky to fully assess whether bank customers are falling behind on repayments.

Still, Zaia forecasts bad debts as a proportion of loan balances to return to more normal levels, around 14 basis points in fiscal 2023, up from 2 basis points in fiscal 2022.

Importantly, this is in line with the five-year historical average of 13 basis points.

“For context, this is far below levels recorded during the global financial crisis, where the banks reported bad debts as a proportion of loan balances of 76 basis points,” Zaia said.

His view is supported by the larger offset account balances by many borrowers, who also have made payments in advance, as also highlighted in the banks’ fiscal 2022 results. The economy also remains sound for now given low unemployment.

“These circumstances should afford borrowers the time to pare back discretionary spending and correct their financial situations to reduce the chance of defaulting,” Zaia says.

What it means for dividends

Banks will remain prudent, Zaia says. Shareholders should not expect any additional capital returned in the form of increased dividend or buybacks.

Zaia expects payout ratios of around 70% to remain achievable for the next five years, he says, given the low credit growth environment where less capital needs to be retained to finance that growth.

"After resetting dividend payout ratios, we think dividends can be maintained and should
grow in line with earnings," Zaia says. 

"Share price weakness in most of the nonmajor banks relative to the majors has pushed dividend yields to very attractive levels."

Top picks in the sector

Of the big four banks, Zaia says Westpac (WBC) and ANZ (ANZ) remain the top picks.

"As the second-largest lender in Australia, we remain confident the funding cost advantages wide-moat-rated Westpac Banking enjoys will see a return to strong profits and returns on equity over time," he says. 

"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 leaves the bank trading at an attractive fully franked dividend yield."

Strong competition and slow mortgage approbal times during COVID cost ANZ material home loan market share.

But Zaia suspects the share price does not factor in how rising cash rates will help the bank's margins improve, adding an increased headcount and investments to digitise processes should make the wide-moat bank competitive again.

"Granted while this comes with added operating expenses, it should help drive earnings growth and returns on equity," Zaia says. 

Wide-moat ANZ and Westpac both hold a 4-star rating, with a fair value estimate of $31.00 and $29.00 respectively.