Farewell cheap loans, hello big four profits? Editor's note
Rising interest rates signal that margin squeeze could finally be coming to at end for Australia's big four banks.
If Thursday’s $1.3 trillion rout on Wall Street is anything to go by, rising inflation and interest rate hikes are no friends of investors. As reported by Bloomberg, "a day after celebrating the Federal Reserve’s signal that it wouldn’t be making any jumbo-sized moves, traders woke up on Thursday deciding that the central bank will struggle to fight high inflation amid the lingering threat of a recession". Eye-watering declines followed, the tech-heavy Nasdaq 100 delivering the biggest one-day drop since September 2020.
Signals from today’s volatile market are confusing. Traders are bullish one day and bearish the next as they place bets on the pace of rising rates, Fed chair Jerome Powell’s ability to engineer a soft landing and how the ‘end of easy money’ will impact markets. But if we put aside market gyrations for a moment, and zoom out to the biggest picture, some clear trends emerge.
There’s no sidestepping the fact that global equity markets have had a rotten start to 2022 with speculative corners of the market like non-profitable tech leading the declines. There’s no safety in bonds either. This incredible chart from Bianco Research shows the Bloomberg Global Aggregate Index, which measures the performance of global investment grade fixed income securities, has lost more than 10% this year, putting bonds on track for their worst year in decades.
But amid the turmoil, there’s some good news on the horizon for Australia’s banks. First-half reporting from two of the big four this week revealed solid numbers. National Australia Bank’s (ASX: NAB) profits were up 8% alongside decent growth in home loans and strong growth in business lending. Profits dipped 5% at Australia & New Zealand Banking Group (ASX: ANZ) but beat analyst's expectations. The juicy stuff is in what’s to come.
Writing in Morningstar this week, banking analyst Nathan Zaia said both banks will benefit from the upcoming rate rise cycle. Yes, you read that correctly – higher rates are good for Australian bank profitability. Zaia’s thesis hinges on forecast increases to net interest margins – or NIM – meaning the amount of money that a bank is earning in interest on loans compared to the amount it is paying in interest on deposits.
Historically, banks have passed through the RBA’s hikes to borrowers (as we saw them do this week), meaning they can charge more each month for loans. Both economists and the bond markets forecast rates to continue rising over the next year, stretching above 2% if you can believe it. Customers switching to variable mortgages from lower-margin fixed-rate loans are also a win for the banks. But, on the deposit side, some savings accounts will see an immediate boost to their rates, but not all – and the same goes for term deposits where only CBA this week increased their rates. The banks also continue to collect fees from transaction accounts, which they don’t pay interest on, as well as term deposits that have rates locked in from years prior. In short, banks’ funding costs aren’t moving by the same amount as their income, hence margins should expand.
Zaia anticipates that banks with more funding from customer deposits and transaction and saving accounts will be the biggest beneficiaries. Commonwealth Bank and Westpac are the standouts, but he says everyone is set to benefit. He expects NIM recovery for banks to kick in from 2023.
“We see considerable scope for major banks to reprice loans upward to improve margins, given the significant cost and switching cost advantages the four wide-moat-rated major banks enjoy over smaller competitors,” Zaia says, noting that around 65% of Australian banks' home loans are at variable rates.
“Our forecasts assume net interest income for the Australian major banks increases between 25% to 35% from fiscal 2021 levels. With strong capital positions and dividend payout ratios reset, dividend growth is likely to be similarly strong.”
Margins have been falling for years, squeezed between more than a decade of falling rates and fierce competition for mortgages customers. Zaia points out that cheap credit and wholesale funding has weakened the big four’s advantage and enabled smaller lenders to compete and cut into profitability. He adds that the Banking Royal Commission added to competitive pressures as mortgage brokers gobbled up greater lending volumes, forcing banks to be ‘sharp’ on their turnaround times and pricing to win business.
As always, there are caveats. Some of the tailwinds that have helped banks over the last two years are beginning to unwind, namely that savers who have seen next to no returns from their cash deposits have a reason to lock their funds away in more expensive term deposits as rates rise. Competition for home loans is also a factor which ANZ boss Shayne Elliott says shows no signs of abating. Interest rate tailwinds aren't a quick-fix remedy for all the issues facing the banks. ANZ watched market share erode due to slow approval times in home lending, while the market remains pessimistic about Westpac’s home loan performance and ability to reduce costs.
From a valuation perspective, Zaia sees significant dispersion between the banks that have operated best recent years, namely, Commonwealth Bank and NAB, and those that have had some mishaps, namely, Westpac and ANZ. Westpac alone screens as undervalued and is due to report its first-half earnings on Monday. While borrowers had little to cheer about this week, bank shareholders and depositors could finally be in for some luck.
For more on this topic, I recommend Zaia’s deep dive on the subject ‘Farewell Cheap Loans, Bank Shareholders and Depositors Cheer on Rate Rises’, available to Morningstar Investor subscribers.
More from Morningstar this week:
How high will interest rates go? Economists, markets at odds with billions at stake
Mike Cannon-Brookes takes stake in AGL, plans to derail demerger
End of an era: RBA lifts cash rate for the first time in more than a decade
Cash rate backflip leaves the RBA governor red-faced, as it should