I. Sector landscape and outlook
Banks have been hit hard by the pandemic, and rapidly evolving infectious disease is giving a hard time to market participants in assessing the underlying value. There had been a decent pick-up in leading indicators recently but increasing new outbreaks and associated lockdowns continue to remain prime risks. After lagging throughout most part of the recovery in markets since late March, there were substantial upside moves in bank shares in late May. This was primarily due to successful containment of initial wave followed by a gradual re-opening.
It had been so convincing that economists also revised forecasts since initial containment efforts yielded better than expected results. Even the International Monetary Fund (IMF) also upgraded Australia’s outlook with a lower contraction than earlier forecast. This very unpredictable and uncertain environment with evolving virus outbreaks continues to threaten the flow of economic activity. Likewise, the lockdown in Melbourne has now pushed the recovery further ahead.
Let us now look at steps taken by the Government to aid the economic lifeline, the banks.
Loan holidays and Government support
Australian Banks have recently announced the additional measures for customers (households and businesses) who have availed the loan moratoriums. Borrowers who remain financially distressed now have options at the end of six-month period, including further deferral of four months.
Figure 1: Deferred Loans
Source: Australian Banking Association
Banks will also provide loan restructuring to those who have a liquidity problem, failing to be eligible for restructuring will pave the way for deferral of an additional four months. It is expected that customers who have the capacity should resume repayments.
Between April 28 to June 19, the Australian Banking Association (ABA) noted that $236 billion worth of loans were deferred with business loans of $175 billion, and household loans of $60 billion. This does not include customers who started repaying.
Interestingly, the size of new business loans outpaced business deferrals, and large corporations availed around $104 billion worth of new business loans. This may also indicate that more businesses refinanced their existing debt, perhaps at lower interest rates.
Australian Government has also been fiscally-strong to unleash one of the largest stimulus packages as a pie of GDP. Within the package, JobKeeper has been fairly efficient in keeping the dislocation minimal and consumption alive, but with the recent extension until March 2021, it has further delayed the end of life-support to core economy.
Although eligibility and payment size has changed, the JobKeeper and JobSeeker payment will continue to be paid to eligible candidates. Once the Government concludes these payments, banks will have more clarification on expected and incurred loan losses.
Government has launched 50% guaranteed SME loans in collaboration with banks. This month, the scheme was upgraded after it ends in September. Starting from October, the new SME loans will have new features, including larger size, secured lending options, longer terms.
SME loan scheme is also further facilitated by the $90 billion funding facility, which was increased up to $150 billion, to banks by the Reserve Bank of Australia (RBA).
Loan deferrals and social support payments have supported the economy, but banks will have more clarity on their assumptions once customers resume their loan repayments, and when the household economy starts walking without stretchers in the absence of support payments.
The Government has stepped up to the plate, now let us gauge how the banks are faring on the fundamental front.
Loan losses, capital and dividends
Given that loans are on deferrals, it is challenging for banks to forecast any potential losses now, and visibility would be better once customers start repaying loans and any potential arrears are recorded. Moreover, the end of support payments would also provide clarity on potential financial distress in the economy.
Figure 2: Non-performing loans of ADIs
Source: APRA Quarterly ADI Statistics
With these two uncertain variables, and continuously changing economic forecasts on the back of evolving new infections and lockdowns, the expected credit loss provisions by banks would continue to remain volatile as variables used in model scenarios for stress testing keep changing.
Incurring losses and provisions would require the banks to source further capital to maintain prudential standards and capital ratios. Although the Australian Prudential Regulation Authority (APRA) has allowed banks to breach capital ratio targets in the wake of COVID-19, banks would need to rebuild capital over time, and Basel III implementation is also due in January 2023.
Figure 3: Key Ratios of ADIs
Source: APRA Quarterly ADI Statistics
As a result, dividend payments by some banks may not be optimal at the current state. The amount of funds released on dividends may lower the ability of a bank to meet its capital requirements, which means a need for additional equity capital raising.
Recently, the APRA has allowed banks to distribute up to 50% of their profits as dividends in FY20 provided that they remain strong under a range of stress testing scenarios, and efficiently manage capital through fresh equity raise or dividend reinvestment plans.
Banks have been wading through unprecedented times, let us now decipher RBA’s moves to support the banks in this tough operating environment.
Inflation and interest rates
In its July meeting, the RBA noted that downturn had been less severe than expected. Consumer spending, manufacturing, construction was better than anticipated in May and June. Furthermore, labour markets were also better than expectations in May.
Figure 4: Australian Government Bond Yield (in %)
Source: RBA
It also believed that JobKeeper and JobSeeker payments have provided support to household income and consumption. Additionally, labour market conditions have also been better than earlier expected, but remained very weak.
Financial markets had been operating efficiently with 3-year Government Bond yield stable at 25 bps, and the RBA was not required to purchase bonds for some time. Australian banks now have funding costs at historic lows with sufficient access to funds.
The RBA kept the cash rate unchanged at 0.25%, and yield target of 3-year Government bond was also 0.25%. It also affirmed that yield-targeting would continue until there is progress on full employment and the inflation target. It continues to track the inflation target range of 2% to 3%, and the cash rate would not be increased until there is progress on its mandate – full employment and stable prices.
Figure 5: Consumer Price Index (in %)
Source: ABS
According to the Australian Bureau of Statistics (ABS), the Consumer Price Inflation (CPI) was down by 1.9% in June quarter, marking the largest quarterly fall in the history of CPI. The significant falls were recorded in child-care, automotive fuel, school and rents. Over the year to June quarter, CPI fell 0.3% compared to an increase of 2.2% in over the year period to March quarter.
In the early stages of the pandemic, the Government made childcare free for the households, resulting in a sharp fall in prices. Australian Treasury, in its latest forecast, expects consumer price index to hit 1.25% over the year to June 2021.
let us now look at some macro conditions that have a direct bearing on bank sector prospects.
Macro fundamentals are stabilising, but remain weak
Although labour market conditions had been better than expected, they are generally bad. Many Australians have lost jobs and experienced reduced working hours. However, the June data from ABS suggest that number of working hours rose by 4%, after falling in April and May.
Figure 6: Labour market indicators (in %)
Source: ABS
The unemployment rate increased 0.4 percentage points to 7.4% (21-year high) in June from May, and participation also improved by 1.3 percentage points to 64% from 62.7% in May.
Australian Treasury expects the unemployment rate to scale higher over the remainder of 2020 with a peak of 9.25% in December quarter. It anticipates the unemployment rate to come lower starting from 2021, and the unemployment rate is forecasted at 8.75% in June 2021 quarter.
Figure 7: Change in payroll jobs between 14 March and 11 July, by State and Territory
Source: ABS
AAA credit rating of Australian bonds: Credit ratings of Australian Government bonds directly impact the corporate and public bond markets. A deterioration in Australian Government bonds will also mean a deterioration in the creditworthiness of banks as well as businesses, and credit costs would shoot higher.
Since Australia was among the countries who effectively contained the initial wave and initiated re-openings, the expected economic deterioration forecast had to be re-evaluated and upgraded. Australia also entered the crisis with a position of strength with a sustainable budget.
JobKeeper costs were going to be materially lower than earlier anticipated, but the Government has now extended the support until March next year albeit with lesser payments. Australia’s rating influencing factors like current account surplus, labour markets and commodity prices have been resilient.
As a result, Australia could be relatively better placed to sustain AAA rating compared to its AAA peers. But the lockdown in Melbourne will have an impact on the economic recovery, and NSW’s outbreaks have the propensity to transform into a second wave, which would be another detrimental consequence.
Vaccine – the ultimate catalyst for the resumption: Vaccine development by many businesses has reached advanced stages of human trials. Markets continue to react to the progress made by vaccine developers. A successful development of a vaccine will be a strong tailwind for markets given that there is a huge monetary and fiscal stimulus in the system.
Results of the initial human trials by some of the frontrunner have been encouraging. Earlier this month, Oxford University announced that trial results indicated the drug was able to trigger strong immune responses through antibodies and T-cells.
Similarly, there were encouraging results coming out of the trials conducted by BioNTech/Pfizer, CanSino Biologics and Moderna, which has also started Phase III trial of its vaccine. Inovio is also starting Phase II/III trials of its vaccine this summer. There are a number of vaccines by many developers currently in the pipeline, and further information would flow as they continue to progress.
Let us now gauge through the foreseeable risks that the banking sector is exposed to.
Risks to banking companies
- Banks continue to incur provisions related to Haynes Royal Commission, and class action suits, proceedings by regulators are also ongoing against banks.
- The second wave in further states would also mean deteriorating economic conditions, and a country-wide lockdown could be most damaging.
- Once COVID 19 support comes to an end, there would be more clarity on the bad debts, loan arrears, and any potential capital needs of banks.
- Economic recovery is a precursor for banks to do well over the future, and any delays in the revival will cause delays to the recovery in the banking system as well.
The Government has played its part to support the economy from going into a tailspin, and the same is validated by the strength in the AUD. The firm prices of commodities have also helped the Australian economy to steady the course and these factors should induce some element of confidence in the policymakers and businesses at large to prepare for the future. The banking sector is at the crossroads with uncertainty still looming large.
II. Investment theme and stocks under discussion (ANZ, NAB, WBC and CBA)
After understanding the recent trends in the industry, let’s now look at four players from the industry those are listed on the Australian Stock Exchange. To assess the same, companies’ stocks are evaluated based on ‘Price/Book Value’ methodology.
- ASX: ANZ (AUSTRALIA AND NEW ZEALAND BANKING GROUP LIMITED)
(Recommendation: Buy, Potential Upside: Low Double Digit, Mcap – A$ 51.3 Billion)
Australia and New Zealand Banking Group Limited provides a range of banking and financial products and services. The group’s operations span Australia, New Zealand, and a number of countries in the Asia Pacific region, the United Kingdom, France, Germany and the United States.
Valuation
Our illustrative valuation model suggests that the stock has a potential upside of ~22% on 29 July 2020 closing price. We have considered Westpac Banking Corp (ASX: WBC), Bank of Queensland Ltd (ASX: BOQ), and National Australia Bank Ltd (ASX: NAB) etc., as a peer group for the comparison purpose.
- ASX: NAB (NATIONAL AUSTRALIA BANK LIMITED)
(Recommendation: Buy, Potential Upside: Low Double Digit, Mcap – A$ 58.9 Billion)
National Australia Bank Limited is a financial services company. The principal activities of the Company include banking services, international banking, investment banking, wealth management services, trustee and nominee service.
Valuation
Our illustrative valuation model suggests that the stock has a potential upside of ~21% on 29 July 2020 closing price. We have considered Westpac Banking Corp (ASX: WBC), Bank of Queensland Ltd (ASX: BOQ), and Australia and New Zealand Banking Group Ltd (ASX: ANZ) etc., as a peer group for the comparison purpose.
- ASX: WBC (WESTPAC BANKING CORPORATION)
(Recommendation: Buy, Potential Upside: Low Double Digit, Mcap – A$ 63.06 Billion)
Westpac is Australia's first bank with a range of innovative financial services to support the personal, business or corporate banking needs of the consumers.
Valuation
Our illustrative valuation model suggests that the stock has a potential upside of ~16% on 29 July 2020 closing price. We have considered Commonwealth Bank of Australia (ASX: CBA), Bank of Queensland Ltd (ASX: BOQ), and Australia and New Zealand Banking Group Ltd (ASX: ANZ) etc., as a peer group for the comparison purpose.
- ASX: CBA (COMMONWEALTH BANK OF AUSTRALIA)
(Recommendation: Watch, Potential Upside: Low Single Digit, Mcap – A$ 127.8 Billion)
Commonwealth Bank of Australia is a provider of financial services, including retail, business and institutional banking, funds management, superannuation, general insurance, broking services and finance company activities.
Valuation
Our illustrative valuation model suggests that the stock has a potential upside of ~3% on 29 July 2020 closing price. We have considered National Bank of Australia (ASX: NAB), Macquarie Group Ltd (ASX: MQG), and Australia and New Zealand Banking Group Ltd (ASX: ANZ) etc., as a peer group for the comparison purpose.
Note: All the recommendations and the calculations are based on the closing price of 29 July 2020. The financial information has been retrieved from the respective company’s website and Refinitiv, Thomson Reuters. Recommendations are valid at 30 July 2020 prices as well.
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