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Morningstar | ANZ Updated Star Rating from 20 Feb 2019

As expected, wide-moat Australia and New Zealand Banking Group’s, or ANZ Bank's, first-quarter fiscal 2019 update focused on capital, funding, lending growth and asset quality, with no news on earnings. Credit quality is stable with a loan loss expense of just AUD 156 million for the quarter, representing a very low annualised loss rate of 10 basis points. Capital levels remain at peer highs with a common equity Tier 1 capital ratio of 11.3% at Dec. 31, 2018. The pro forma capital ratio of 11.6% is well ahead of Australian Prudential Regulation Authority’s 10.5% required by January 2020. Funding and liquidity settings remain strong. The on-market share buyback continues and is designed to partially offset the steady and orderly build-up in capital.

The trading update was broadly in line with our expectations, underpinning our AUD 29 per share valuation. But loan growth continues to disappoint. At current prices, the stock is broadly fairly valued, trading 6% below our valuation. The stock is currently trading at an attractive fiscal 2019 dividend yield of 6.0% or 8.5% grossed-up. We like the strong capital position, modestly higher risk-weighted assets and sound asset quality. ANZ Bank has a relatively low level of lending to higher-risk residential interest-only borrowers at 22% of its Australian home loan portfolio, about AUD 60 billion at Sept. 30, 2018.

A key negative from the update is the bank's home loan growth continues to slow. Factors are tighter credit conditions, higher regulatory mortgage risk weights and very competitive operating conditions particularly for high-quality owner-occupier home loans. But the upside we see is the bank’s willingness to refocus on growing the residential loan book to at least the system growth rate. No change to our fiscal 2019 forecasts, with cash earnings of AUD 6.7 billion, just below analyst consensus of AUD 6.8 billion, and total fully franked dividends of AUD 1.61 per share based on a 67% dividend payout ratio.

We forecast the payout to trend lower over time to the top end of the bank’s medium-term target of 60%-65% of cash earnings by end fiscal 2023. Despite the positives, residential loan growth continues to disappoint with ANZ Bank continuing to grow below the system rate. Australian home loan system growth was 4.2% for the year to Dec. 31, 2018 with ANZ Bank’s performance underwhelming at just 1.0% year on year growth. It would seem the bank has gone too hard on reducing exposures to the residential investor lending, including both principal and interest and interest only categories, and implementing tougher policies and processes. ANZ Bank’s high-quality residential owner occupied loans increased 3.5% year on year, but investor loan balances declined 3.8% year on year.

Reduced demand from borrowers is being fuelled by increased uncertainty around tougher regulation and falling house prices with buyer confidence suffering. We expect ANZ Bank will increase its appetite for residential investor loans and potentially ease-up on some of the bank’s tough policy and process requirements. Weakness in home lending was offset by a stronger result in the corporate loan sector with an approximately AUD 4 billion increase in corporate credit risk-weighted assets in the quarter. Total credit risk-weighted assets increased AUD 10 billion in the quarter.

Our group loan growth forecast remains at 3.5% for fiscal 2019 and at similar annual levels out to end fiscal 2023 on the back of modest GDP growth, good employment growth, solid population growth, low interest rates and eventually less stringent underwriting standards.

Net interest margins were not specified but must be under pressure as funding costs remain elevated with short-term and long-term wholesale funding costs increasing in leading up to the end of calendar 2018. Wholesale interest spreads have retreated somewhat in recent weeks with the key 90-day bank bill swap rate back below 2.00%, currently sitting around 1.95%.

The update did not refer to revenue and expense trends and we make no changes to our full year fiscal 2019 forecasts. Despite an annualised first-quarter loan loss rate of just 10 basis points, we maintain our fiscal 2019 loan loss rate forecast of 12 basis points with loan arrears rates ticking up with pockets of loan stress. Our forecast fiscal 2019 loan loss rate of 12 basis points will be the equal lowest for 13 years if achieved.

Despite modestly higher wholesale funding costs in the quarter we maintain our forecast net interest margin at 1.90% reflecting upside due to the September 2018 variable home loan repricing. Despite softer loan growth in the quarter, we are comfortable with the transition with ANZ Bank making good progress disposing noncore assets, growing capital levels, building the profitable Australian and New Zealand businesses and most importantly continuing to benefit from improved asset quality.

Interest-only lending was a low 11.4% of total new residential lending in the quarter, well within the now retired macroprudential limit of 30%. A total of AUD 6.3 billion of interest only loans (customer initiated and contractual) switched to principal and interest in the quarter, compared with AUD 5.8 billion per quarter on average for the eight quarters from first-quarter fiscal 2017 to fourth-quarter fiscal 2018. Another AUD 4.0 billion in interest-only maturities are scheduled for the three months ending March 31, 2019.

The total amount of contractual switching scheduled for the remainder of fiscal 2019 is AUD 12 billion, including the AUD 4.0 billion in second-quarter fiscal 2019. ANZ Bank customers converting ahead of schedule during the quarter was in line with the quarterly average for fiscal 2018 was AUD 2 billion. We remain confident the interest-only switching process will not result in material increases in residential loan losses. ANZ Bank’s group mortgage 90 plus days past due loan arrears remain at a low 0.62% of total home loans. Australian investor home loan delinquencies increased modestly with owner-occupied delinquencies broadly stable. Group gross impaired assets were stable at AUD 2.0 billion.