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Morningstar | Solid Credit Growth and Favourable Economic Conditions Support Major Bank Earnings

Economic conditions in Australia remain broadly positive (despite unrelenting negative publicity to the contrary), with the operating environment providing solid foundations for the four wide-moat major banks to grow and prosper. Based on Australian Prudential Regulation Authority's, or APRA’s, banking statistics for June 2018, the rate of growth in residential lending is growing modestly, not falling sharply as many commentators have postulated. Despite fears of a credit crunch, the residential lending market is both robust and resilient with the increase in owner-occupier lending offsetting the sharp fall in investor lending.

Major bank earnings are far more resilient than many believe, and we expect a solid underlying performance when Commonwealth Bank of Australia reports fiscal 2018 results on Aug. 8, 2018. The biggest short-term concern for the major banks is the likely fallout from the Royal Commission. Bank reputations and public trust have taken a severe beating since the start of the Royal Commission--the most obvious outcome to-date being a tightening in consumer lending standards and a slowdown in new lending. No changes to fair value estimates. At current prices, Westpac is most attractive trading 17% below our AUD 35 valuation. National Australia Bank is 13% below our AUD 32 valuation, and Commonwealth Bank of Australia is 11% below our AUD 83 valuation. ANZ Bank is trading close to our AUD 30 valuation.

On balance the economy is "OK" with robust GDP growth. Despite our optimistic view on macroeconomic conditions, EPS growth is slowing for the banks. There is not a single cause for the moderating growth, rather a combination of slower lending growth, pressure on net interest margins, higher compliance, remediation and regulatory spending, and more normal bad debt costs. Our major bank average annual forecast EPS growth for the next five years is a pedestrian 3% with fully franked dividends forecast to grow less than 2% per year.

The economic facts simply do not support the overwhelmingly negative view on financial press and some economic commentators on the Australian economy, corporate Australia, and particularly the major banks. In our view, robust underlying fundamentals support bank earnings, particularly their pricing power, dominant market positions, high returns on equity and attractive fully franked dividend yields. In early July, the Reserve Bank of Australia notes “business conditions are positive and non-mining business investment is continuing to increase.”

Positives are numerous and include: strong export growth; strong employment growth; low unemployment; respectable credit growth; historically low interest rates; elevated building approvals; massive infrastructure spending; a federal budget surplus not too far away; strong population growth; elevated levels of public spending; a strong rebound in company profits; and high business and consumer confidence. Unsurprisingly, the stock market is at 10-year highs, and there is still a further catalyst on the horizon of individual tax cuts.

Australia's sovereign AAA credit rating is not under threat, and despite expectations of a credit crunch, May housing finance approvals increased 0.5% compared with April, but are down 3.7% year on year and the growth in housing credit outstanding increased a healthy 5.6% year on year to June 30, 2018.

On the downside, weak wages growth continues to drag on consumption, average household debt continues to increase, the household savings ratio continues to fall, retail sales remain sluggish and international trade tensions could derail Australia's most important trading partner, China. House prices are weakening, and we expect an orderly and healthy correction, not a widespread collapse.

Australia's economy remains resilient, as evidenced by better-than-expected March quarter 2018 national accounts released in early June. As we have long argued, recession fears are overblown with exports, consumption and public sector spending underpinning broader economic activity, despite soft wages growth.

Respectable real GDP growth of 3.1% for the year to March 2018 continues to support modestly positive operating conditions for the major banks. GDP growth is now back at trend levels and broadly in line with our medium-term annual GDP growth rate forecasts in the 2.5-3.0% range. The RBA's July 3 statement on the July monetary policy decision forecast GDP growth “to average a bit above 3% in 2018 and 2019” with CPI inflation “to be a bit above 2% in 2018” and unemployment likely to steadily decline “after being steady at around 5.5% for much of the past year.”

Wide-moat Westpac is our preferred Australian major bank due to stronger earnings growth potential, superior operational efficiency and impressive returns on equity. Warranting an Exemplary stewardship rating, the firm has a good track record of discipline around cost control and risk management. Continued focus on productivity improvement and sustainable lending growth, without the distractions of exiting underperforming legacy assets like some peers, supports steady but sustainable EPS growth. At current prices the fiscal 2018 forecast dividend yield of 6.5% provides valuation support. We expect Westpac’s lending growth slowly eases to around 4% per year. Combined with broadly stable net interest margins and benign credit quality, we expect low-single-digit earnings per share growth. We forecast average dividend growth of 2% during the next five years, despite expecting the payout ratio to decline to 74% in fiscal 2022 from 78% in fiscal 2017.

Based on APRA data, Australian home lending by all banks increased a healthy 5.3% in the year ended June 30, 2018 to AUD 1,672 billion. Household deposits, held by all authorised deposit taking institutions, increased 5.7% in the year to June 30 to AUD 893 billion. The ratio of household deposits to home loans has eased modestly but is still a relatively high 53%. The ratio had steadily increased during the past 10 years from 43% in January 2008.

Commonwealth Bank and Westpac dominate the consumer space with 25.4% and 24.5% respectively of the national bank home loan market. The two NSW-based, consumer-focused banks also hold 28.4% and 23.5%, respectively, of the national household deposit market. Westpac has the strongest 12-month Australian home loan growth of the major banks expanding 5.5% in the year to June 30, 2018, with National Australia Bank up 5.3%, ANZ Bank up 4.5%, and Commonwealth Bank slipping to a 3.5% increase. Westpac and National Australia Bank benefit from the strongest household deposit growth rates of 6.8% and 5.5% respectively.

RBA total private system credit, including banks and nonbank lenders, expanded a healthy 4.5% for the year ended June 30, 2018, but the annual rate of growth continues to moderate from recent highs of 6.7% in late 2015. This is not necessarily a bad outcome as tighter residential lending restrictions should result in lower future credit losses. Lower loan growth reduces pressure on new wholesale funding requirements and all important regulatory capital ratios. The slowdown in housing credit is not a cause for alarm and we consider the healthy correction 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 net interest margins much more significant contributors to bank profits.

Housing credit growth continues to ease but remains a healthy 5.6% increase in the year to June 2018, with owner occupied housing up a strong 7.8% year on year, and investment housing falling sharply to only 1.6% year on year. The annual growth rate in investment housing credit has decelerated sharply from an eight-year peak of 11% in May 2015 following APRA's macro prudential restrictions of an 10% annual growth cap and a 30% maximum flow cap on interest only residential loans.

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 increasingly clear nonbank lenders continue to take share from the banks. The combination of repricing investment loans to a premium to owner occupied 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.

Worryingly, the annual growth rate for business credit has slowed to 3.2% at June 2018 from an eight-year high of 7.3% in April 2016. In the depths of the global financial crisis, demand for business credit evaporated, with business credit slumping 7.5% in the year ended Nov. 30, 2009. Despite the declining trend, business credit growth is volatile and based on positive macro conditions we expect a steady recovery on the back of increased business investment.

Net interest margins are likely to trend down caused by higher wholesale funding costs and strong competition for new lending. Most smaller lenders in Australia have increased home loan variable interest rates by around 10-15 basis points during the past month in response to surging short term wholesale interest rates. But at this stage major bank home loan interest rates are unchanged. If short-term wholesale interest rates remain at current elevated levels, to preserve net interest margins, the major banks are likely to implement out-of-cycle interest rate increases in the next few months.

In the short-term money markets, spreads moved higher during the past three to four months with the BBSW rate hitting a two-year high of 2.12% on June 21 with the BBSW-OIS spread peaking at 0.62% up from 0.30% six months earlier. The regional banks and smaller banks cited these higher funding costs as a key reason behind their interest rate rise on mortgages. The measure of BBSW-OIS is usually cited as a measure of the banking system's health, and a higher spread indicates that liquidity is drying up. The BBSW-OIS spread has partially retraced with the latest read at 0.46%, still elevated, but 16 basis points lower than mid-June peaks.

The key drivers supporting solid credit growth are historically low interest rates with the cash rate at 1.5% and the 10-year bond rates currently around 2.70%. Other drivers include shifting patterns of economic growth as the economy transitions from the commodities investment boom and a weaker exchange rate. Economic momentum also comes from an unemployment at near five-year lows at 5.4%, and the sustained growth of the more densely populated states of NSW and Victoria as well as south eastern Queensland.

Despite the surprisingly strong March 2018 quarter GDP outcome, the four wide-moat-rated major banks continue to face challenging conditions with Australia’s economy susceptible to a wide range of risks. Political and regulatory uncertainty is not helping business confidence, weak wages growth is drag on consumption and the RBA's inflation target, businesses continue to underinvest in growth initiatives, external shocks such as increasingly hostile trade tensions between the U.S. and key trading nations, particularly China. The Royal Commission in Australia is hugely destabilising for the banking and broader financial sector.

The move to global quantitative tightening--albeit at a glacial pace--from nearly a decade of quantitative easing creates potential consequences as does the Brexit shambles, with no real resolution insight. The antics of the U.S. President could derail global growth and international bond markets have started to reprice in anticipation of softer economic conditions ahead. Sudden economic shifts in China could have major consequences for the Australia economy, the financial system and by extension the Australian major banks. The most damaging downside risk to bank earnings is the potential for an exogenous shock triggering a global downturn that drags the Australian economy into recession--but this is not our base case. We view this unlikely scenario as a major setback that will impact not just banks but all business sectors to varying degrees.