In a market stunned by nearly daily profit warnings, the early signs are that major banks are set to be one sector which does 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. While this isn’t exciting, it does mean investors can earn 8-10 per cent 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 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. Bad debts expense surprised on the downside at just 12 basis points of gross loans and interest margins were flat. Banks can hold margins steady or eke out small increases by repricing loan books this year.
Last week the Reserve Bank issued updated forecasts for GDP growth to accelerate from 1.5-2.5 per cent, 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 six per cent. The acceleration in underlying inflation the RBA forecasts over the same period, from 1.75 per cent to a range of 1.5-2.5 per cent 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 per cent.
If unemployment stays below seven per cent, GDP growth improves and the upturn in Australian inflation and interest rates is slow, then Australia will avoid a generalised house price crash despite households’ scary rates of leverage. This is becoming our base case because the labour market was already set to improve in 2017 as the mining retrenchments of 2016 taper, and this is with slow incomes growth now. Any acceleration in domestic income growth 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.
Loan impairments in mining towns and regions increased last year and remain a risk. 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”.
A surprise acceleration in inflation which triggers sharper rises in interest rates is unlikely because surging US shale oil output will cap oil prices at US$60 per barrel, population ageing continues to dampen demand for goods and services, millions remain out of work globally nine years on from the GFC and wage inflation in the US remains moderate despite low measured unemployment.
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 one per cent but expenses rose five per cent – negative ‘jaws’, so earnings fell one per cent. 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 $200 million of productivity savings but it might need the full year to get there.
After NAB’s update we upgraded our valuation to $33.50 because this year’s 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 per cent discount to the NAB valuation suggests a $30.00 entry price, where the dividend yield is a solid 6.6 per cent.
Originally published in The Australian on Tuesday 14th February 2017.