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Morningstar | Major Bank Pricing Power (Mostly) Intact Despite Intense Legal, Political, and Regulatory Pressure

Solid operating conditions for Australia's wide-moat-rated major banks are being completely overshadowed by the negative sentiment and damaging revelations raised to date at the Royal Commission into misconduct in the banking, superannuation, and financial services industry. The Royal Commission is due to release an interim report by the end of September, with the final report due in February 2019. We expect the interim report to focus on residential lending standards, vertical integration of wealth businesses, grandfathered commissions in the wealth industry, a review of mortgage broker commission, and potentially the retail superannuation sector. The insurance sector will likely be included in the final report.

Despite an outlook for tighter regulatory and compliance requirements, the biggest risk for the major banks is the potential for a credit squeeze triggering an economic downturn as borrower demand softens at the same time as stricter lending criteria bites. However, the banks remain well supported by strong economic fundamentals as global and domestic economic conditions improve. Australian GDP for the June quarter came in at a respectable 3.4% year-on-year growth rate, with strong employment growth, record high export volumes and values, continued positive net immigration, solid credit growth of around 4.5%, and record high infrastructure investment. House prices have retraced slightly, and we expect further modest house prices weakness in the year ahead.

At current prices, Westpac Banking Corporation is most undervalued, trading 20% below our valuation. Commonwealth Bank of Australia and National Australia Bank are each trading  13% below our valuations,  and Australia and New Zealand Banking Group is trading 5% below our valuation. We are comfortable with our modest earnings forecasts, with EPS expected to grow an average of 2.4% per year to fiscal 2022, and near-term catalysts to drive share prices materially higher are difficult to find.

Despite solid fundamentals, the sector is suffering from elevated uncertainty, particularly around pricing risk, credit risk, and operating risk. In response to mounting regulatory pressure, the banks are investing to improve reporting and risk management systems at a cost to underlying profitability. There is a risk the Royal Commission recommendations could be tougher than expected, and combined with weakening house prices, slowing credit growth, increasing trade tensions, and further economic slowdown in China, bank share prices could face further short-term pressure. Major bank share prices are all down from 12-month highs, with ANZ Bank down 9%, Commonwealth Bank down 15%, National Australia Bank down 15%, and Westpac Bank down 18%.

It was comforting to see three of the four major banks (ANZ Bank, Commonwealth Bank and Westpac Bank) increase variable home loan rates between 14 and 16 basis points in late August/early September without too much regulatory, political, and media heat. Short-term wholesale funding costs increased several months ago and remain elevated, exerting pressure on net interest margins. We are surprised with National Australia Bank’s decision to hold home loan interest rates steady, as pressure on margins is meaningful. Major bank pricing power remains undiminished, despite intense negative scrutiny from the Royal Commission, politicians, and media.

As always, there are plenty of risks to earnings and stock prices for the major banks, not the least being unfavourable Royal Commission outcomes, a tougher regulatory environment, slowing economic conditions in Australia, the long-running fear of an economic correction in China, and of course major banks' exposure to expensive housing. Global tightening of liquidity could raise Australian bank wholesale funding costs further. In these circumstances, bank net interest margins could contract if borrowing rates are not increased for Australian corporate, commercial, and housing loans.

Political and regulatory risks are increasing, with a range of issues unfolding. A potential change of government could affect the Australian housing market and the major bank oligopoly. All eyes are on the next election scheduled by May 2019 and a likely change of government. The policies of the current government opposition, the Australian Labor party, on negative gearing residential property, capital gains tax discounts, tax treatment of trusts, and the removal of cash refunds of surplus franking credits are all indirectly negative to bank stock prices. Potential changes to bank compliance requirements, regulatory framework, and the current 0.06% bank levy are all creating uncertainty.

Despite the political and regulatory risks, we expect improved productivity and benign credit quality to support future fully franked dividends delivering attractive dividend yields in the 6%-7% range. We forecast average annual dividend growth of just 1.4% to fiscal 2022, with average payouts forecast to decline to 72% in fiscal 2022 from 76% in fiscal 2017. Major bank forward price/earnings ratios have contracted to an average around 12 times from 13 times a year ago and are below longer-term averages around 12.7 times. Returns on equity are expected to average above 14% during the next five years, with Commonwealth Bank to stand out at around 15.5%. Political uncertainty is not helping business confidence, while weak wage growth is a drag on consumption and the Reserve Bank of Australia inflation target. The most damaging negative 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.