In a market stunned by nearly daily profit warnings before reporting season, the major banks are emerging as one sector that will not disappoint during this first half. National Australia Bank’s first-quarter update was our first window into how the sector was travelling at the end of 2016 and it suggested an outlook for low single digit full-year earnings per share growth and flat dividends. Commonwealth Bank confirmed this with its 1H17 result but increased the interim dividend by one cent. While this isn’t exciting, it does mean investors can earn 8-10% total returns on banks this year if they wait patiently to buy at the right prices.
Market consensus has finally converged to our longstanding view that there will be no major bank equity raisings or dividend cuts this year. NAB’s organic capital generation was strong due to slow loan growth and justifies a flat interim dividend despite a dividend payout ratio above management’s target range. CBA is one of the most strongly capitalised banks in the world.
NAB’s bad debts expense surprised on the downside at just 12 basis points of gross loans and CBA’s equivalent ratio remained low at 17 basis points – also a downside surprise. Stress in CBA’s loan book is confined to Western Australia, where mortgage and personal loan impairments have risen due to last year’s mining redundancies. This remains a risk and there could be spillover to small business loan books in WA. While the bounce in bulk commodity prices will flow to higher mining town incomes with a lag, mortgage insurer Genworth last week forecast “elevated delinquencies in certain regional economies in 2017”.
Elsewhere, major banks have so far managed their exposure to pockets of unit overdevelopment well with no uptick in impairments to related mortgages or loans to property developers. CBA’s property developer clients are having no difficulty settling sales of new units. Major bank exposure to inner-city units and their developers is also very small, so these pockets of real estate are likely to remain a non-event for major banks. By and large the sector will prove to have managed its risks here well.
NAB reported interest margins as broadly stable. CBA’s margin declined four basis points but the exit rate at the end of the half would have been higher due to repricing of existing loans. In response to higher funding costs as cheaper wholesale funding from several years ago rolls off, banks can hold margins steady or eke out small increases by repricing loan books this year. Ongoing competition will limit any gains to a few basis points and continue to constrain interest revenue growth.
Admittedly December bank results benefited from elevated trading and hedging activity by corporate clients in response to last year’s geopolitically driven volatility in financial markets. So far CY17 has seen a sharp reduction in this volatility; if sustained this typically lumpy item will diminish.

CBA chief executive, Ian Narev
Source. AFR
The main credit quality risk is not inner-city units or even Western Australia. Major banks and their mortgage borrowers are vulnerable to any broad, sustained surge in unemployment due to elevated household gearing, and this is a risk we monitor daily. 2017 should see a steady unemployment rate as last year’s full-time mining redundancies fade, offset by growth in participation in the official labour market. Last week the Reserve Bank issued updated forecasts for GDP growth to accelerate from 1.5-2.5%, over the year to June 2017, to 2.5-3.5% over the year to December 2017. That is a sharp acceleration and would, if achieved, restrain the unemployment rate below 6%. The acceleration in underlying inflation the RBA forecasts over the same period, from 1.75% to a range of 1.5-2.5% followed by the same range in subsequent years, would not require more than gradual normalisation of the cash rate from the current record low of 1.50%.
We monitor risks to house prices, mortgage impairments and major bank earnings very closely. Our base case is the unemployment rate will stabilise between 5.5% and 6.0% and interest rates will rise slowly because inflation will remain low well into 2018. This is a benign outlook for major bank loan impairments. Any acceleration in domestic income growth this year, as CBA management predicted, strengthens the case. Although some mortgage borrowers will be so leveraged they default as rates rise, impairments should be isolated given moderate average loan-to-valuation ratios on major bank balance sheets and strong buffers in home loan portfolios.
The main risk to bank earnings in 2017 is actually disappointment on operating costs, especially wage increases, regulatory and compliance costs. In its first quarter NAB grew revenue 1% but expenses rose 5% – negative ‘jaws’, so earnings fell 1%. NAB’s expenses were also inflated by elevated redundancy costs – a sign of the pressure on banks to do something about costs when revenue growth is slow, and the upfront price of doing so. NAB is targeting positive jaws with $200m of productivity savings but might need the full year to get there.
CBA’s “underlying” operating cost growth of just 1.4% seemed like a positive surprise but total operating costs jumped 8.9% due to amortisation of capitalised software costs. While this growth rate is unlikely to repeat, it does illustrate the pressure on costs from the need to invest in the digital technology customers expect and which banks need to remain competitive. Regulatory and compliance cost inflation will also continue.
After NAB’s update we upgraded our valuation to $33.50 because this years’ generally positive outlook for banking profitability no longer requires us to be as conservative relative to consensus as we were. Our strategy this year includes adding to positions in banks when volatility creates opportunities. A 10% discount to the NAB valuation suggests a $30.00 entry price, where the dividend yield is a solid 6.6%. Our CBA valuation is under review though our early assessment is the stock is trading a touch above intrinsic value.

Figure 1. NAB Valuation and Market Stats
Source. StocksInValue