EUR 850.00 For Business Accounts Only

Morningstar | Both RBA and IMF Paint a Rosy Picture for the Australian Economy - But Can it Last?

The minutes of the November monetary policy meeting of the Reserve Bank of Australia, or RBA, and the latest annual report on Australia by the International Monetary Fund, or IMF, paint a rosy picture of the near-term outlook for the Australian economy. Both institutions expect strong economic growth, supported by low interest rates, above trend growth in Australia’s major trading partners, strong population growth and stronger than expected terms of trade. Despite these positive views there are alternative, less optimistic views on the broader outlook. But we think the positive economic conditions can last for at least the next two years with the major banks to benefit. Despite a softening housing market, both for house prices and housing investment, the RBA notes “business investment had been stronger than forecast a year earlier.” Recent strength in nonmining business investment is expected to make a significant contribution to output growth during the next few years. Non-residential construction work is booming with a long tail of infrastructure construction expected to support employment growth and consumption demand. The key weakness in the economy is persistently low wages growth.

A positive outlook for the economy is important for the outlook for the major banks, as the banks are such an integral part of the economy, dominating financial markets, new lending, deposit gathering and most importantly responsible for the strength of the financial system. Despite the positive economic outlook, we recently reduced our major bank fair value estimates by 3%-6% due to increasing regulatory, compliance and Royal Commission pressures. Our earnings forecasts for the next few years are subdued, but we are confident dividends are sustainable underpinned by good capital generation, modest credit growth, strong loan quality and high absolute profitability. Currently the major banks are undervalued with Westpac most attractively priced at 22% below.

Returns on equity have fallen, but we expect average returns on equity of around 12.5-13.0% during our forecast period for Australia’s four major banks. Based on Morningstar’s global equity research, average returns on equity for 2019 are 14.6% for Canadian banks covered, 13.6% for the big Chinese banks, 12.5% for Hong Kong banks, 11.9% for Singapore banks, 10.8% for big U.S. banks, and 7.3% big U.K. banks.

We expect housing loan growth to slowly ease to around 3.5% per year in the next few years from about 5.2% currently. Combined with broadly stable net interest margins and benign credit quality, we expect low-single-digit earnings per share growth during our forecast period.

The RBA noted “exports had continued to make a significant contribution to growth in output over the preceding year.” Resource exports continue to power ahead, with service and manufacturing exports well supported by strong global growth and the lower Australian dollar over 2018. The RBA states that commodity prices, particularly prices for bulk commodities, had held up more than expected during the previous 12 months and due to this higher starting point “the forecast for Australia’s terms of trade had been revised higher for the next few years owing to a reassessment of the expected strength in global demand for commodities, particularly from China and India.” But terms of trade or net exports are volatile, and despite being positive in third quarter 2018, could deteriorate quickly if the trade war escalates.

Escalating trade tensions between China and the U.S. could drag on the positive economic outlook for Australia in terms of net exports and GDP growth for 2019 and beyond. On the downside, U.S. GDP growth has probably peaked. Australia’s major trading partners, China and U.S., are likely slowing. Capital Economics forecasts U.S. 10-year bond yields at 2.5% in 2019 from around 3.0% currently, due to slowing economic growth. The eurozone is also slowing, and a post Brexit U.K. will be struggling.

The IMF’s positive view focused on “Australia’s recent strong growth is expected to continue in the near term, further reducing slack in the economy and leading the way to gradual upward pressure on wages and prices.” Importantly, the IMF contends “the cooling of the housing market is welcome and can be weathered in a strong economy.” The IMF make the important point that despite recent modest declines in house prices, national house prices have risen about 70% in the past 10 years, with Sydney prices doubling and Melbourne prices up 90%. The IMF’s baseline case is for an orderly correction incorporating assumptions of “no significant oversupply, the presence of other strong growth drivers, and a resilient banking sector continuing to extend credit to support economic growth.”

The IMF highlights risks to its positive view including “a weaker than expected near term outlook in China, coupled with further rising global protectionism and trade tensions…”, a sharp tightening in global financial conditions could push up bank funding costs, weak wages growth could pressure domestic demand, business investment could be softer than expected and high household debt levels could pressure consumption.

The RBA expects GDP growth around 3.5% on average over 2018 and 2019, before easing modestly to around 3% towards the end of 2020. The ramp up in “LNG exports is expected to reach capacity production levels by the end of 2019.” Inflation is under control and poses no near-term threat to the economy. CPI inflation was 1.9% over the year to September and had been around 2% for over a decade. The RBA expects inflation to “increase gradually over time as spare capacity in the economy declines.” The RBA cash rate remains at 1.5% for a record length of time and money market futures pricing suggest no change till late 2019 at the earliest. Some business economists are not predicting an increase in the cash rate till 2020.

Consumption growth continues around the 3% level despite soft household income growth. Retail sales continue at a relatively modest rate and the RBA expects household consumption to remain around 3% during the next few years. The RBA expects growth in household income to increase around 3% per years for the next few years.

Labour market conditions remain strong with most employment growth in “high-quality” full-time employment, but full-time employment is declining as a percentage of total. Despite a high participation rate, unemployment has steadily declined to a six year low of 5% in September and the RBA expect the rate to gradually decline further to around 4.75% by mid 2020. The RBA highlighted the potential for unemployment to fall at a faster than expected rate in the near term. Despite lower unemployment, wages growth remains soft with Australia’s seasonally adjusted wage price index up 2.3% year on year in the September quarter of 2018. The September quarter result was modestly higher than the 2.1% per quarter increase reported for the three previous quarters and the RBA has made a modest increase in the outlook for wages growth.

The RBA does not appear overly concerned about the softening housing market and expects the orderly decline in average capital city house prices to continue, but population growth would provide some support to demand for housing. Residential building approvals fell in the September quarter, but the RBA expects “the large pipeline of work yet to be done was expected to support dwelling investment at a high level over the following year or two.” The Australian Bureau of Statistics does not include infrastructure work done in nonresidential construction. Total value of building approvals, both residential and nonresidential has fallen for 11 consecutive months.

Based on RBA monthly banking statistics overall year on year credit growth has stabilised around 4.6% during the past four months to end September 2018. Slowing housing credit growth has been offset by a pickup in business credit growth. Year-on-year business credit growth of 4.4% to end September 2018 is up from a year on rear growth rate of 3.2% at end June 2018. System home loan growth slowed to a still healthy year-on-year growth rate of 5.2% for the year to September 2018. Owner occupier home loan growth is a healthy 6.5% on an annualised six month ended basis, with residential investment loan growth close to zero. Housing lending by nonbanks has continued to grow strongly, although these lenders remain a small part of the market. Home loan credit growth is slowing due to a combination of softer demand from borrowers, tighter macro prudential rules and tougher underwriting standards by lenders. We expect system housing credit growth to slow further to around 3.5% during the next few years and it is hard to see why growth is going to turn up in the near term due to likely changes to negative gearing if implemented as a result of a change of government in 2019.

Bank funding costs moved up during 2018, with most of the increase due to higher short term money market rates in the six months to June 30, 2018. Money market rates have eased modestly but remain elevated. Domestic spreads between average lending rates and average deposit costs have remained broadly stable for many years particularly for Commonwealth Bank and Westpac Bank. In our view major banks pricing power is judiciously applied as necessary to offset higher funding costs. Despite soft margin outcomes for second half fiscal 2018, we believe recent home loan repricing will more than offset the impact of higher funding costs. In addition, short term wholesale funding costs have eased a little since peaking towards the end of June. The 90-day BBSW rates have stabilised around 1.92%-1.94% from a peak of 2.12% at end June 2018.

Markets and treasury margins have suffered, principally due to less opportunities in markets. Ongoing changes in the mortgage portfolio mix with less, higher margin, ‘interest-only’ lending, increased “front book” discounting on new mortgages and increased remediation costs have also weighed on outcomes. These negatives were partially offset by some deposit repricing positively impacting margins and the variable home loan repricing. We forecast margins to increase in fiscal 2019 compared with second half fiscal 2018 for the major banks excluding National Australia Bank. Westpac Bank is most undervalued at 22% below our AUD 33 valuation and National Australia Bank at a 20% discount to our AUD 30 valuation. Commonwealth Bank is trading at a 12% discount to our AUD 80 valuation and ANZ Bank is trading 12% below our AUD 29 valuation.

Westpac Bank reported second-half fiscal 2018 margins down a significant 12 basis points to 2.05% from 2.17% for first half fiscal 2018 due to higher short term funding costs (five basis points), lower Treasury margins (two basis points), mortgage discounting and interest only conversions (four basis points) and remediation provisions (two basis points). Westpac Bank’s first-half fiscal 2018 margins increased seven basis points to 2.17%, the highest level since 2012 on the back of mortgage repricing in second-half 2017. The average 90 day BBSW rate for second half fiscal 2018 was 2.00% compared with the average of 1.78% for first half fiscal 2018. Westpac Bank indicated the group exit margin at Sept. 30, 2018 was 2.03% excluding markets and treasury margins of approximately of 0.10%. Higher funding costs increased competition, mix changes, customer remediation costs and lower treasury and markets margin income were identified as the prime cause of the margin pressure.

Commonwealth Bank reported a two basis point decline in margins to 2.14% for the six months ended June 30, 2018 with higher short term funding costs accounting for two basis points, higher long term wholesale funding costs detracting two basis points, partially offset by deposit repricing of two basis points. Home loan discounting and switching cost two basis points of margin with a positive two basis point from institutional lending and New Zealand. We expect Commonwealth Bank margins to be broadly in fiscal 2019, in line with second half fiscal 2018 of 2.15%. We forecast fiscal 2019 loan growth of 3.3% and loan losses to increase modestly to 0.16% from 0.15% in fiscal 2018. If achieved, we think this will be a good outcome considering the challenges experienced during fiscal 2018. Commonwealth Bank is expecting home loan system growth to ease to approximately 4% by end fiscal 2019 from 5.6% for fiscal 2018. Modestly lower than forecast loan growth does not have much of an impact on our valuation. We forecast Commonwealth Bank’s margin to average 2.13% during the five years to end fiscal 2023.

ANZ Bank’s fiscal 2018 results highlighted changing dynamics in the home loan market, noting the combined impact of regulatory changes and bank-initiated tightening during the past three years has meaningfully reduced average maximum borrowing capacity. An emerging trend is residential borrowers are increasingly turning to nonbank lenders where the two-year loan growth is estimated at 28% versus 11% for banks. However, bank lending is off a very large base and non bank lending is off a very small base. The rapid growth in the less regulated non-bank sector could end badly when, or if, the financial system experiences the next liquidity crisis, mirroring the 2007 event experienced in the early stages of the GFC crisis that resulted in many non-bank lenders exiting the sector.

ANZ Bank's Australian home loans in the September half grew at a very subdued 0.4%, about 0.2 times the system growth rate of 2.1% for the six months to Sept. 30, 2018, reflecting the bank's focus on selected property areas, stricter lending criteria, and ongoing competition in the industry. Second half fiscal 2018 margins declined steeply, by 0.11% to 1.82% with lower markets and treasury income, higher remediation costs and higher wholesale higher funding costs detracting from margin performance. The recent 0.16% increase in variable home loan interest rates should assist in boosting fiscal 2019 margins to our forecast rate of 1.90%, compared with 1.87% for fiscal 2018. We forecast ANZ Bank’s margin to average 1.90% during the five years to end fiscal 2023.

National Australia Bank’s second half fiscal 2018 net interest margins fell by a modest 0.03% to 1.84%, again due to elevated short-term wholesale funding costs, ongoing intense competition in the home lending segment, particularly for residential owner occupier loans and weaker markets and treasury income. Lower margins were expected considering elevated 90-day BBSW rates. National Australia Bank’s net interest margin for the year ended Sept. 30, 2018 was flat at 1.85% with our fiscal 2019 forecast at 1.86%. We forecast National Australia Bank’s margin to average 1.86% during the five years to end fiscal 2023.

Westpac Bank is our preferred Australian major bank because of its earnings growth potential, superior operational efficiency, and impressive returns on equity. Westpac Bank’s core profitability is strong, management is not as distracted as peers, business momentum is good, and dividends can grow modestly. Warranting an Exemplary stewardship rating, the firm has a good record of discipline around cost control and risk management. At current prices, the fiscal 2019 forecast dividend yield of 7.4% provides some valuation support. In the near term, net interest margins have been supported by politically unpopular loan repricing to offset higher wholesale market funding costs.

We forecast average dividend growth of 1.2% during the next five years, despite expecting the payout ratio to decline to 75% in fiscal 2023 from 80% in fiscal 2018. Capital levels continue to build, and we anticipate no problems achieving the regulator's definition of "unquestionably strong" by the January 2020 deadline. In the medium term, we expect modest economic growth in Australia continuing to support favourable operating conditions for the major banks. Expected real (nominal) GDP growth of 3.5% (4.5%) per year underpins our credit growth assumptions. Low unemployment levels and continued low official interest rates should keep loan losses subdued, despite softening house prices.