Don’t Bank on the Big Four

Don’t Bank on the Big Four

2 Mar, 2023 | Stock Insight

Australia’s big four banks recently released their financial results for the first half of the 2023 financial year (second half of the 2022 calendar year). While the share prices of ANZ, NAB and Westpac are largely unchanged from a few years ago (and CBA has shown a healthy increase), operationally it’s been a tumultuous period given the effects of the pandemic and dramatic changes in the housing market.

Overall, the banks’ profits were significantly higher than the prior corresponding period (the first half of FY22), mostly due to lower impairment charges (the banks took ‘provisions’ for expected loan losses during the early part of the pandemic, and because the economy has recovered more quickly and strongly than expected, they were able to reverse most of these provisions in later periods). Banking is a cyclical business though, and banks generally ‘over-earn’ in good economic times (their profits are higher than their average earnings through the economic cycle) and ‘under-earn’ in a weaker economy (profits are lower than their cycle average). The recent healthy profits are therefore a bit ‘old news,’ and the outlook for future earnings doesn’t look quite so rosy for the nation’s big four.

Early Warning Signs

One of the most startling revelations came from Westpac, the nation’s second-biggest mortgage lender, which detailed that approximately half (45% or $212 billion) of its $471 billion in housing loans are “at risk of exceeding risk buffers.” This means that customers haven’t been assessed as able to repay their loans at mortgage rates that are expected to occur in the near future. This is partly because the previous 7% minimum “floor” mortgage rate was removed as a requirement early in the pandemic when the Reserve Bank of Australia (RBA) slashed the cash rate to a record low 0.1 per cent. With a generous 3-year ‘term funding scheme’ that meant the banks could lend at low rates and still be profitable, and a buffer that was only required to be 3% above the bank’s mortgage rate, a lot of borrowers were assessed based on rates much lower than 7%. Now though, with the overnight cash rate (OCR) already at 3.35%, many borrowers will have to make repayments that are higher than the maximum that was assumed on their loan applications.


Lowe-r for Longer, no Longer

Although the RBA has increased the OCR at 9 consecutive meetings (the fastest pace in history), Governor Phillip Lowe sees further increases as necessary over the coming months (officially dispelling his pseudonym  ‘Lowe-r for longer’). This is the RBA’s attempt to reduce the highest inflation the country has experienced since 1990, which clocked in at 7.8% for the full year 2022. While there are some indications inflation may be easing (the unemployment rate rose slightly in January to 3.7%, for example), this does not appear to be dissuading the RBA. Market expectations are now for 3 further increases in the coming months, taking the OCR to an 11-year high of 4.1%.

This is particularly concerning for borrowers facing a so-called “mortgage cliff,” where their mortgage rates will switch from low fixed rates signed during the pandemic to the substantially higher variable rates of today. These homeowners could be facing a jump from around 2% that they’ve paid for the past 2-3 years to a minimum of 5% (with repayments increasing a staggering $1,800 a month for the average mortgage holder compared to May 2022 when the RBA first began its hiking cycle). This will impact around $96 billion and $92 billion in loans, respectively, at Australia’s two biggest mortgage lenders, CBA and Westpac, over the next year or so.

Westpac CEO Peter King called these interest rate rises a “blunt tool” for reducing inflation, and warned that if the OCR reaches 4%, many borrowers would need either a pay rise or to cut their spending to afford the repayments. CBA chief Matt Comyn already sees signs that households are drawing on their savings buffers, which were built up during the earlier stages of the pandemic.


It’s the Economy, Stupid

The combination of decades-high inflation and rapidly rising interest rates is having a devastating impact on consumer sentiment, which according to Westpac, recently fell back into “deep pessimism.” The Westpac-Melbourne Institute Consumer Sentiment Index tumbled 6.9 per cent in February to 78.5 – a near-record low result (while above the pandemic low of 75.6 in April 2020, it is incredibly below the Global Financial Crisis recording of 79). The survey showed particularly low readings for the nation’s views on family finances, the near-term outlook for the economy, and whether now is a good time for purchasing a major household item. In fact, ‘family finances versus a year ago’ was the lowest reading since the depths of the early 1990s “recession we had to have,” while the recording for consumers with a mortgage was the one of the lowest since the survey began, in the mid-1970s. Companies are already beginning to see the impacts, with retailers like JB Hi-Fi (ASX:JBH) and gambling provider Tabcorp (ASX:TAH) indicating softer trading periods ahead as inflation and higher interest rates take their effect on discretionary spending. Both the RBA and the federal Treasury also expect the economy to “slow considerably this year”, with Treasurer Jim Chalmers expecting a “very difficult time for Australians.”

One Step Forward, Two Steps Back?

Bank stocks generally benefit from a higher/rising interest rate environment, particularly those banks like CBA with such strong deposit franchises. This is because they’re typically able to raise loan rates faster than the rates paid on deposits (much to the ire of the public), as well as how many deposits don’t generate any interest (think of the balance in your main transaction account). It’s easy for this benefit to be more than offset by an economic slowdown though, as loan growth slows and loan losses rise.

Time to Broaden Your Horizons?

For those wanting to maintain their exposure to financial companies, it might be worth taking a more global perspective. In the United States, market leaders Bank of America (NYSE: BAC) and JPMorganChase (NYSE: JPM) have only approximately 10% market share in a much larger market (providing significant opportunity for future growth), benefit more from rising interest rates (they have more commercial lending and mortgages in the U.S. are typically fixed for 30 years), and have much lower leverage (assets/equity) than the Australian banks. They also trade at only 1.6x and 1.9x Tangible Book Value (TBV), respectively, significantly below Australia’s market leader CBA at 2.6x TBV (NAB 1.7x, WBC 1.3x, ANZ 1.2x). In the U.K., leading franchises Lloyds Banking Group (1.0x TBV) and NatWest (1.1x TBV) have finally recovered from the dramatic bailouts of the GFC, and are attractively valued relative to the Australian banks given their strong profitability (as measured by high returns on tangible equity).

Don’t Bank on a Rosy Future

There’s no doubt that the big four Australian banks are solid businesses with a long history of profitability and healthy dividends. That gives them widespread appeal to ASX-focused investors, particularly with the benefit of franking credits (a 30% tax credit on dividends for Australian taxpayers, even if they don’t typically pay any income tax). Excluding CBA, however, the big banks have delivered very modest returns (by equity standards) over the past 5, 10 and 15 year periods. What’s more, the mortgage market has become increasingly competitive, particularly from Macquarie Group (ASX: MQG), and the economic outlook looks to be one of the most challenging in the past 30 years. The combination of high house prices, significant homeowner debt, high inflation, and a rapidly rising interest rate environment could limit the return outlook for years to come.

Sign Up to Our Weekly Stock Insights

* Indicates required field



Popular Topics