Sector Report

Australian Banks: Sloth or Rat?

by Brian Johnson / Feb 9, 2017

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The unwind of the long-running Australian bank AUD dividend yield carry trade has commenced. Prior to the share-price peaks in April 2015, Australian bank earnings benefitted from robust system credit growth, pricing power on mortgage lending, sub-cycle loan losses given writeback gains and model-generated declining regulatory capital releases. EPS growth was strong and DPS growth even stronger as dividend payout ratios expanded. Now that system credit growth is slowing, reduced mortgage pricing power sees NIMs vulnerable to rising deposit rates, loan loss charges will rise as writeback gains diminish and regulatory capital intensity is rising. EPS growth will slow and DPS cuts are likely. On a proforma basis, we estimate the major banks are A$27bn short of CET1 capital. Fears of a collapse in the Australian housing bubble have resurfaced and we are concerned regarding WA housing and looming apartment settlement risk in Melbourne and Brisbane. We remain underweight on Australian banks:

• Globally banks look challenged by policy settings. Australian banks are relatively expensive, challenged by lower interest rates, face the prospect of rising loan losses and rising capital. The long-running Australian bank AUD dividend carry trade looks to be unwinding

• We think the major banks are still A$27bn short of CET1 capital – the recap cycle is not yet over but APRA has pushed resolution of the FSI “unquestionably strong” recommendation out by a further 12 months

• Australian bank forward EPS growth is set to slow

• Rising CET1 and mid-cycle earnings would see sustainable div payout ratio cut from 70% to 60% and dividends fall 12% to 24%

• Increased scrutiny sees the banks losing their pricing power on lending products which may be problematic given rising deposit funding costs

• As Australian interest rates fell households and businesses releveraged rising real asset values to generate system credit growth of ~6%. The end of this releveraging cycle sees system credit growth likely to slow

• Fears about a collapse in the Australian housing bubble remain elevated. We remain concerned about (i) WA housing where CBA is overexposed, and (ii) Settlement risk on A$16bn of excess apartment overbuild over the next two years in Melbourne and Brisbane – we estimate the banks carry ~A$56bn of EAD to commercial residential developers/investors. We expect any major house price falls would be confined to the affected regions On notional mid-cycle recapitalised earnings the Australian banks don’t look particularly cheap. We recommend underweighting the sector but would look to participate in the recapitalisations