EUR 850.00 For Business Accounts Only

Morningstar | Credit Growth Continues to Slide, But a Post Election Rebound is Likely and Welcome

Worryingly, private credit system growth continues to slow with the Reserve Bank of Australia, or RBA’s, print of 3.7% for the year to April 2019 the weakest since October 2013. The RBA data includes all banks and non-bank lenders. Housing credit growth continues its downward slide with year-on-year growth of 3.9%, with owner-occupier growth a solid 5.5% offset by weak investor lending growth of just 0.6%. Business credit growth is holding around 4.5% levels and personal credit growth remains negative, contracting 2.8% for the year to April. We expect the decline in credit growth to continue for several months, but at a reduced pace, with some improvement starting in December quarter 2019.

Despite very recent renewed confidence, the macro outlook has softened during the past 12 months, with Australian GDP slowing from robust levels of 4% annualised in first-half calendar 2018 to a much weaker outcome of 1% annualised for second-half 2018. Expectations for weak GDP growth in calendar 2019 combined with below target inflation, pressured the RBA to cut the cash rate in early June to a new record low 1.25% from 1.5%. Some business economists predict two, three or even four cash rate cuts in the next 12-18 months, including the June 2019 cut. First-quarter 2019 GDP printed a weak result of 0.4% for the quarter and 1.8% for year to end March 2019. The economy lost momentum primarily due to a softer housing market and weaker consumer segment with a tightening of lending standards and persistent weak wages growth the main culprits.

Following the welcome rebound in wide-moat major bank stock prices since the election, the banks are trading closer to our fair value estimates. National Australia Bank and Westpac Banking Corporation are trading 11% below our respective fair value estimates of AUD 30 and AUD 31 per share. Australia and New Zealand Banking Group is trading 3% below our AUD 29 fair value and Commonwealth Bank of Australia just 1% below our AUD 80 fair value.

It will take at least six months before there is strong enough evidence of a sustained improvement in the housing market. We are confident in the long-term outlook for the major banks and see upside to our forecasts if the housing market starts to recover sooner than expected. We are confident major bank management actions to restructure wealth management businesses, invest in technology, maintain loan quality, manage margins, and improve productivity will deliver modest earnings growth, assuming demand for housing credit stages a good recovery. At current prices, major bank fully franked dividend yields are about 6%, grossing to 8.5%.

Major bank stock prices have been under considerable pressure during the previous 18 months due to a weaker property market, tougher bank lending standards, short-selling pressure, and the not inconsiderable fallout from the Royal Commission. Our major bank valuations are based on credit growth around 3.5% per year to end 2023, stable net interest margins, or NIMs, around 2.00%, modest increase loan losses, averaging 0.17%, modest improvements in productivity with the cost/income ratio averaging 44% and returns on equity averaging 13%. Following a disappointing fiscal 2019, we expect dividend growth of just 1% per year with payout ratios decreasing to more sustainable levels around 76% by the 2023. There is upside to our forecast credit growth assumptions.

Anecdotally, the Liberal/National Coalition electoral victory has triggered a surge in home loan finance inquiries at banks and mortgage brokers. The rate of decline in Sydney and Melbourne house prices has slowed to the lowest in 12 months and auction clearance rates have rebounded with Sydney experiencing a 66% clearance rate for the first weekend in June. CoreLogic results point to national dwelling values down just 0.4% in May. Sydney and Melbourne house prices declined 0.5% and 0.3% in May, the lowest monthly decline since March 2018. CoreLogic noted “it’s still very early days but the improvement appears to mirror the post-election recovery and improved auction clearance rates.” Global credit rating agency, Standard & Poor’s, forecasts the downturn in Sydney and Melbourne house prices to continue for six to 12 months as a result of weak consumer and business sentiment. The ratings agency noted it “will wait for further evidence of stabilisation before concluding that related economic risks facing Australian banks have eased.”

Calendar-2019 GDP will be soft and likely well below trend growth of about 2.75%. We think it is too early to forecast another two or three cash rate cuts in the next year or so, but downside risks are increasing, and it will require a sustained rebound in economic activity to avoid further declines in GDP growth. We are not forecasting a recession, but the economy is slowing and will need a strong post-election confidence boost to kick start growth. But we are quietly confident a reboot in demand for home loans, increased dwelling construction, stable house prices, improved consumer and business confidence, increased public spending, record high infrastructure investment, solid jobs growth and elevated prices for key commodities, personal income tax cuts and historically low interest rates will support GDP growth. We expect another one or two quarters of soft GDP growth, but economic conditions should improve going into 2020.

If the Australian economy deteriorated and registered two consecutive quarters of negative GDP, it would end Australia’s enviable record of 28 years without a recession. In a recession, we would expect negative credit growth, higher unemployment leading to increased bad debts and reduced spending across the economy, among other things. In this scenario, our major bank valuations would decline and depending on the severity, capital raisings may be necessary. A recession is not our base case and we expect the Australian economy to muddle through with medium-term GDP growth in the 2%-3% range.

Credit growth has been declining at a faster rate during the past 12 months due to tighter bank lending standards, macroprudential restrictions, Labor’s wide-ranging tax policies, a weaker housing market, low business and consumer confidence, high household debt, weak wages growth, political uncertainty leading up to the federal election, increasing trade tensions between the U.S. and China and increasing economic uncertainty.

Based on Australian Prudential Regulation Authority's, or APRA’s, banking statistics for April 2019, the 12-month growth rate in residential loans outstanding for all banks continues to slow, falling sharply to 3.3% in April from 7.1% two years previously in April 2017. Fears of restricted credit flow have been realised and continue to weigh on sentiment. The increase in owner-occupier lending has partially offset the sharp fall in investor lending, but owner-occupier growth rate is slowing.

Residential investment lending accounts for about 33% of total residential credit outstanding. Based on the comparison of total system RBA data and total bank APRA data, it is clear smaller banks and nonbank lenders continue to take share from the major banks. The combination of repricing investment loans to a premium to owner-occupier loans, more stringent assessment of borrower incomes and expenses, increased loan/valuation ratios, reducing the terms of interest-only loans for owner-occupiers, and tightening lending standards for foreign buyers, has slowed the growth rate in housing lending for the major banks.

Housing finance commitments continue to trend lower with total commitments down 2.3% in March 2019 and 15.5% lower than March 2018. Owner-occupier housing finance commitments are down 2.6% in March and 12.4% from a year ago and investment housing commitments are down 1.5% in March, and 22.8% from a year ago. Clearly, investment housing commitments have been most affected by APRA’s macroprudential changes and Labor’s taxation policies.

Following the recent surprise federal election result, we have seen the removal of a raft of potential negative political, structural, and taxation concerns from the banking system and the housing market. Labor’s policy platform included a wide range of direct and indirect negatives for the housing market and banking sector, but Labor’s electoral loss has swept aside these headwinds, and opened-up the possibility of better times ahead for the struggling housing market.

It is early days, but the electoral outcome has been well received by the residential property sector and combined with regulatory easing, interest rate cuts and government initiatives give strong hope for a stabilisation in property prices. In addition to the residential property-friendly political outcome, we saw APRA announce potential changes to mortgage serviceability benchmarks, and the RBA reducing the short-term interest rate benchmark. On a positive note, we see the electoral result as a pivotal point providing a floor under the market with somewhat improved conditions ahead. But, despite the post-election hype, the property market is still soft and tough lending underwriting standards continue to slow the flow of housing credit. It is too early to adjust up our home loan credit growth forecasts for the major banks and we will be watching future ABS housing finance approval data for early signs of a recovery in the home loan market.

Despite initial positives from the election, an easing of home lending criteria and lower interest rates, we expect only a mild boost to future credit growth and the housing market. Our longer-term credit growth forecasts remain around 3.5% per year for the major banks, including New Zealand operations. We cannot overestimate the positive impact of lower interest rates on the housing market and following the RBA’s 0.25% cut in the cash rate, we saw the four major banks immediately announce reductions in interest rates for key standard variable home loan products.

Not surprisingly, Commonwealth Bank and National Australia Bank reduced variable home loan rates by the full 0.25%, with Westpac cutting 0.20% and ANZ Bank cutting 0.18%. Short-term wholesale funding costs have fallen sharply during the previous two to three months in expectation of a cut(s) in the cash rate. We estimate the announced variable home loan interest rate cuts will place some modest pressure on NIMs despite the banks continuing to benefit from lower short-term wholesale funding costs.

Despite the margin pressure, we think it was an appropriate response by the major banks to pass on most if not all the 0.25% cut in the official cash rate, as we see the political downside of holding back too much of the 0.25% was just not worth the pain, particularly in the early stages of the new government.

But the problem for the major banks is how to respond to the next potential 0.25% cut in the official cash rate, possibly as soon as August 2019. Despite considerable political pressure, we think the major banks could (or should) only pass on about half the next 0.25% cut in the cash rate, with even lower pass-on rates for subsequent cash rate cuts (if they eventuate). If the RBA implement one or more rate cuts during the next 12 months, there will be pressure on bank NIMs as lower interest rates on assets cannot be fully offset by lower rates on liabilities. Some deposit account interest rates are already at or close to zero and cannot be lowered.

To support NIMs, the banks will have to withhold most of the subsequent cash rate decreases, with downside for the broader economy as there will be breakdown in the usually efficient interest rate transmission mechanism between the RBA and the banking system, long seen as a key monetary policy advantage in Australia.

Wide-moat-rated Westpac is our preferred Australian major bank because of good earnings growth potential, superior operational efficiency, and solid returns on equity. The firm has a good record of disciplined cost control and risk management. At current prices, the fiscal 2019 forecast dividend yield is an attractive 6.7%. The stock is undervalued, trading 11% below our AUD 31 fair value estimate. In the near term, NIMs can be supported by politically unpopular loan repricing to offset volatile wholesale funding costs. We expect lending growth to slowly ease to around 3% per year. Combined with broadly stable NIMs and benign credit quality, we expect low-single-digit EPS growth during our forecast period. We forecast flat dividends during the next five years, with the payout ratio declining to 78% in fiscal 2023 from an expected 89% in fiscal 2019. In the medium term, we expect modest economic growth in Australia continuing to support operating conditions for the major banks. Low unemployment and continued low official interest rates should keep loan losses subdued, despite softening housing prices.

Based on APRA data, Australian home lending by all banks increased 3.3% in the year ended April 30, 2019 to AUD 1,711 billion. Household deposits, held by all authorised deposit taking institutions, increased 5.3% in the year to April 30 to AUD 936 billion. The ratio of household deposits to home loans has increased modestly and is still a relatively high 55%. The ratio had steadily increased during the past 11 years from 43% in January 2008.

Commonwealth Bank and Westpac continue to dominate the consumer space with 25.5% and 24.3%, respectively, of the national bank home loan market. The two NSW-based, consumer-focused banks also hold 28.3% and 23.0%, respectively, of the national household deposit market. National Australia Bank and Commonwealth Bank have the strongest 12-month Australian home loan growth of the major banks expanding 3.5% in the year to April 30 with Westpac Bank up 2.5%, ANZ Bank going backwards, incurring a 1% contraction during the same period. National Australia Bank and Commonwealth Bank benefit from the strongest household deposit growth rates of 5.2% and 4.7%, respectively.

Lower loan growth, by itself, is not necessarily a bad outcome as tighter residential lending restrictions should result in lower credit losses in the future. Lower loan growth reduces pressure on wholesale funding requirements and important regulatory capital ratios. The slowdown in housing credit is a near term headwind, but the healthy correction in residential property prices is a positive for longer-term financial system stability. Modestly lower credit growth does not impact bank earnings as much as many believe, with changes in bad debts and NIMs much more significant contributors to bank profits.