We see value in Australian banks, with most trading at material discounts to our fair value estimates. The earnings trajectory is negative as more expensive customer deposits and aggressive mortgage discounting hurts margins despite the tailwind of higher cash rates.

We expect margins to stabilize in 2024 and improve in 2025. There are tentative signs of more rational pricing. With higher funding costs and fewer scale benefits, smaller banks and nonbank lenders are struggling to make adequate returns.

We expect they will follow the majors’ lead on pricing. The number of borrowers in arrears is low but rising as households cut discretionary spending. The major banks hold surplus capital, which provides comfort dividends can be maintained as earnings soften.

Unloved financials

The earnings outlook for general insurers, IAG Group and Suncorp, is positive. Higher claims and reinsurance costs are being matched with higher premium rates.

Additionally, much higher cash rates are driving a material increase in investment income on policyholder and shareholder funds. We prefer the insurance brokers Steadfast, AUB Group, and PSC Insurance Group who ride these tailwinds without the underwriting risk.

Most asset and wealth managers we cover are likely to see earnings recover in fiscal 2024 from cyclically challenged lows in fiscal 2023. Industrywide fund flows are slowly recovering as interest rates stabilize—a trend we foresee continuing throughout fiscal 2024. The resurgence in flows should steady and potentially improve funds under management and fee revenue, especially for better-performing, diversified businesses.

Despite higher earnings from investment income, general insurers Suncorp and Insurance Australia Group continue to lift premium rates. Premium rate increases are necessary for insurers to achieve returns above our 11% cost of equity estimate.

Wide and narrow moats

As stock markets stabilize, investors are slowly reallocating their funds into riskier asset classes like equities. This shift should stabilize funds under management, and hence revenue, of many wealth managers that were adversely affected by prior redemptions.

ANZ Group (ASX: ANZ)

  • Fair value: $31
  • Moat: Wide

ANZ Group has lost material home loan market share, and having less funding sourced from low-cost household customer deposits hurts margins. We suspect the shares do not fully factor in the margin benefit of rising cash rates and process investments which should improve the competitiveness of this wide-moat bank. In recent months, ANZ Group has grown home loans ahead of market, and with no worse margin pressure than peers.

Exposure to corporate lending, which has seen less price competition than mortgages, helps. While improving the loan approval process and customer offering comes with added expenses, they should drive earnings growth and returns on equity. Suncorp Bank should improve bank efficiency if the deal is approved, but integration costs make it unlikely to be materially value-accretive.

Perpetual (ASX: PPT)

  • Fair value: $30.50
  • Moat: Narrow

We believe the market is overlooking narrow-moat Perpetual’s likely earnings growth from better flows and cost reductions. While Perpetual’s investments business is in net outflow, we believe the division’s gradually improving investment performance supports new mandate wins and aids lower redemptions. We also expect staff retention and product distribution efforts to manage outflow risk.

Additionally, we anticipate improved flows for both wealth management and corporate trust from an eventual stabilization in interest rates and macroeconomic conditions, relative to present levels. Both businesses face less competitive intensity relative to the investments business. Elsewhere, there is room for cost reduction from centralizing operations and removing duplicate functions following the acquisition of Pendal, while Perpetual itself is cycling off a period of elevated investment.

Westpac (ASX: WBC)

  • Fair value: $28
  • Moat: Wide

Wide-moat Westpac has lost market share in home loans and pulled its cost-saving targets, but we think it will improve on both fronts. Despite intense competition, we expect margins to benefit from a large customer deposit funding base. Westpac is Australia’s second-largest lender, number two in mortgages and number three in business loans.

Funding cost advantages should allow the bank to reprice loans to generate better margins as smaller banks struggle to make a decent return on equity given higher wholesale funding costs. Bank cost inflation is meaningfully tied to customer remediation and improving risk management, and much of this should dwindle. Market share has stabilized in recent months, supporting our confidence there are no serious loan approval issues. Westpac has surplus capital, is well provisioned, and pays generous fully franked dividends.

Our take on the Big 4 banks in our podcast Investing Compass.