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Where to from here for Australia's wide moat major banks?

David Ellis, CPA  |  12 Apr 2018Text size  Decrease  Increase  |  
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The major banks seem to be operating in parallel universes. On the one hand it is all doom and gloom with investors facing a daily avalanche of negativity, including disturbing revelations from the Royal Commission, Productivity Commission reviews, ASIC inquiries, APRA capital changes, macro-prudential limits on lending and unfriendly policy proposals from the federal opposition to name a few. Not surprisingly, bank share prices have suffered.

On the other hand, Australian major banks continue to benefit from surprisingly solid fundamentals delivering modest earnings growth. Capital levels are strong, loan quality is pristine, the economy continues to chug along at a respectable 2-3% GDP rate, employment growth is strong, credit growth is solid, inflation is low, and the housing market is stabilising. Attractive fully-franked dividends are not under threat and capital returns are possible during the next few years. The risk of a recession in Australia remains low and surprisingly, the federal budget deficit appears to be shrinking faster than expected. This "Goldilocks" operating environment is good for banks and we see it persisting for several years at least.

The incessant news flow from sensationalist media and grandstanding politicians has weighed heavily on bank share prices, offering attractive entry points for investors. Westpac provides best upside, but all four major banks are undervalued relative to our fair value estimates. Investors should remain calm; current headwinds will dissipate after a difficult next 12 months and longer term we expect satisfactory shareholder returns, albeit lower than the stellar returns experienced during the past decade. Major bank forward price earnings ratios have contracted to an average of 12 times from 13 times five months ago and are now below long-term averages. Political and regulatory risks are still rising, but we believe current bank share prices broadly reflect these risks.

Exhibit 1: Major bank forward price to earnings (P/E) ratios

chart Source: Thomson Reuters, Morningstar

Banking is an industry Australia excels in

Make no mistake, banking is an industry Australia really excels in and the four major banks set a global benchmark. The major banks are world class for profitability and shareholder returns, though culture must improve. They boast impressive peer comparisons across operational efficiency, loan quality, risk management, returns on equity, capital levels and liquidity. Balance sheets and funding profiles are significantly stronger than pre-GFC levels and future earnings will withstand digital disruption. Strong fundamentals underpin the outlook for long-term earnings growth.

The major banks are both a strategic and economic necessity for Australia, playing a key role as importers of capital from international markets. Australia has long been unable to raise sufficient capital domestically to fund multi-decade economic expansion. Yet we are one of the wealthiest nations in the world with long-term wealth creation supported by a strong and profitable banking sector.

Geopolitical and economic risks are always present, but manageable

The main risk over the medium term is another global credit crisis, with flow-on implications for domestic lending, house prices, the economy and employment. A credit crisis would make it more difficult and costly for the banks to fund existing lending, creating a slump in lending growth and cause bad debts to rise. However, this is not our base case and in any event the banks have stronger financial positions than pre-GFC and can expect support from the government and the RBA in the event of a crisis.

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Digital disruption from global tech giants such as Google, Apple, Amazon, Alibaba and Tencent as well as start-ups is a risk, but the major banks continue to invest heavily in product and service innovation to retain and grow customer numbers. Despite media and political commentary to the contrary, major bank customers trust their banks to protect their life savings and personal details from cyberattack. Customer trust is a key competitive advantage of the major banks.

A hard landing in China could trigger a collapse in demand for commodities, a collapse in the China property market and significant challenges for China's financial system. Sudden shifts in China could have "first order" impacts on Australia and our major banks. A deterioration in global economic growth and trade flows as international interest rates retrace higher is also a threat. A global credit crisis would increase funding costs and if prolonged would decrease net interest margins, absent customer loan and deposit repricing. But since the GFC, financial system stability is much enhanced, limiting the risk of a global credit crisis and consequent financial contagion.

Political and regulatory risk is increasing with Australia's federal opposition proposing to reduce the attractiveness of Australia's generous dividend franking system for low tax payers. The proposal to remove cash tax refunds for shareholders where imputation credits exceed assessed tax would not be good for retail investors overweight Australian banks, particularly the SMSF sector. Labor's policies aimed at reducing the tax concessions for negative gearing and capital gains tax around investment housing are not bank-friendly either. The next federal election is due before early November 2019 and the opposition holds a commanding lead in the polls. A change in government would not be a good short-term outcome for Australian bank shareholders, but if a change of government does eventuate we are confident the banks will over time manage the disruption and limit the damage.

Royal Commission into misconduct in the banking, superannuation and financial services industry

The Royal Commission is a key risk and casts a long shadow over the major banks and bank share prices. Commissioner Hayne and team impress with brevity, directness and laser-like focus. During the first two weeks of hearings the major banks felt the Royal Commission's "blow torch" focused on consumer lending, home lending and mortgage brokers. At this early stage it looks like the Commissioner is determined to meet the February 2019 timetable. An interim report is due in September 2018. Customer case studies investigated to date have been damaging for the major banks, but the small number of damaging cases investigated by the Royal Commission are not in our view a true representation of the major banks' customer base.

To date the Royal Commission has received about 3,200 public submissions, yet in Australia the Commonwealth Bank (ASX: CBA )has 13.8 million customers and Westpac (ASX: WBC) 10.8 million. Commonwealth Bank has the highest consumer customer satisfaction of major bank peers based on Roy Morgan Research survey results. Roy Morgan's Single Source survey of over 50,000 consumers per annum shows 80.1% of Commonwealth Bank's consumer customers were either satisfied or very satisfied in January 2018. Major banks are likely to tighten lending standards, though not to the point of instigating a credit crunch unleashing disastrous consequences. Increased regulatory oversight restricts cross-sell opportunities, future business growth, investment and innovation for the major banks.

Improved budget outlook reduces financial risk

The federal budget deficit for 2017-18 is now expected to fall from $26 billion to "just" $12 billion and if earnings from energy and resource exports continue to surprise on the upside then the government's current forecast of a budget surplus in 2021 will be reached much earlier. If achieved, this will be a great outcome, likely enabling personal income tax cuts and easing pressure on stretched household finances. The government's chief economic forecaster, the Office of the Chief Economist is more upbeat about export earnings in coming years as the fear of a collapse in commodity prices has not eventuated.

The outlook for iron ore and coal export revenue is softer but remains positive. Iron ore and coal prices are expected to ease, but export volumes are expected to continue increasing. Australia is set to become the world's largest LNG exporter, possibly in 2019. Infrastructure investment is booming, with approximately $96 billion in transport and storage projects underway with the majority taking place in NSW, Victoria and Queensland. Stronger economic growth is a positive for the major banks and could provide better than expected outcomes for bank profits and dividends.

The major banks are sensibly and judiciously balancing the four most important drivers of future shareholder returns - balance sheet growth, funding, loan underwriting standards and capital levels. Despite regulatory headwinds, this balancing act will continue. We forecast modest EPS growth averaging 2.7% per year to fiscal 2022 for the major banks. Near-term catalysts to drive share prices materially higher are difficult to find, but longer term we expect modest credit growth and stable net interest margins to drive top-line revenue growth, while greater investment in technology and cost cutting will reduce bank cost bases.

Housing market stabilises

Australia's housing boom is over, with modest recent price declines in Sydney and to a lesser extent Melbourne. We see this as a good outcome and expect an orderly correction during the next few years as incomes increase relative to house prices. Importantly we do not see signs of a collapse in house prices. Demand for good quality dwellings, close to transport, services and business centres will continue to be supported by strong population growth, solid economic growth, offshore buyers and historically-low interest rates.

Interest rates for owner occupier home loans are at record lows, despite investor and interest-only loans repricing higher. The RBA is unlikely to raise interest rates in 2018 and possibly not till late 2019. Auction clearance rates remain healthy, around 65% nationally. Annual population growth is running at about 1.6% nationally, with Victoria up 2.4% and NSW and Queensland up 1.6% each. Lending for housing is growing at around 6% year-on-year, but will likely slow further due to macro prudential limits and tighter underwriting standards. Record-high jobs growth, with full-time jobs growth a standout, supports a healthy housing market.

The Big Four - Ratings and Metrics

chart Note: Prices and ratings as at 11 April 2018; All four banks' CET1 ratio as at 31 December 2017; Other datapoints are average of 5 year Morningstar forecasts.
Source: Company reports, Morningstar


David Ellis is Morningstar's head of Australian banking research, Australia and New Zealand. Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar.

The author's retirement fund owns shares in all four Australian major banks.


Your feedback on this week’s Overview is always welcome. Send your comments to YMW@morningstar.com. We’d love to hear from you.


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