A review of the banking sector: Where to from here?

28 Apr 2016

By Shadforth Financial Group

Banking is a key sector in the Australian economy and Australian investors’ portfolios. In this month’s Investor Edge, we reflect on the latest banking sector results.

Broadly, the big four banks produced results that were in line with market expectations. Despite this, there has been a pullback in their share prices as a result of global banking concerns. This leaves us with the view that they present a slightly better value . The results of the smaller regional banks, however, were somewhat disappointing as they experienced margin pressures that impacted their earnings. In addition, there are also concerns about earnings quality and earnings growth that are impacting their share price performance.

Keeping bad debts low

The banking sector has been able to keep the amount of bad and doubtful debt to levels below historical averages, mainly due to the strong housing market and low interest rate environment. As the housing market continues to slow, the amount of bad and doubtful debt in the sector will likely increase. The banks’ ability to keep their bad and doubtful debts under control in the future will be put to the test.

Margin pressure

The banking sector will continue to experience margin pressures due to higher funding costs as the market re-prices debt risk. Margins are down near Global Financial Crisis levels and unless banks are able to recover their margins, earnings growth is at risk. We have already seen banks try to recover margins by increasing rates despite the Reserve Bank leaving cash rate unchanged.

From a corporate lending perspective, this area will remain hotly contested and will drag margins lower as the big four banks compete for the corporate lending market to fill the gap left by the slowing residential lending market.

An improving economy

On the positive side, the economy shows signs of improvement. In addition, the potential stabilising of the resources sector and unemployment remaining under control, lowers the risk of a housing market collapse. Property markets and the housing cycle have appeared to slow but are not expected to collapse. Given the expectation that rates remain at existing low levels for longer, combined with steadily improving unemployment, we expect the housing market to continue to remain relatively well supported. In addition, as a result of requirements imposed by the banking regulators, there has been a shift from interest only loans to the less risky owner-occupied mortgages.

We have also seen household debt as a percentage of disposable income, as well as private system credits begin to accelerate again. This should support banking valuations. We have seen most valuation metrics of the major banks improve and the relative yields push higher due to the fall in share prices and their relative underperformance of the index.

Dividend and share price expectations

The slower than expected growth rates from banks, marginal equity issuance and lower margins will most likely result in banks not providing dividend growth but rather maintaining their existing dividends declared . We acknowledge the challenges faced by the sector, however feel that the share prices have started to reflect these and can potentially see a short term re-rate upwards.

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