Update on the Big 4 Banks

Yes, well, reporting season was an interesting one for the banks. The big four banks in particular all reported strong financial updates and they’re well-placed to deliver their strongest revenue growth in over a decade. They’ve been enjoying the benefit of net interest margin expansion as interest rates have been rising, and whilst on the other side of the ledger, deposit rates have remained low. Customer savings rates are also high, with bad debt still very low and balance sheets unquestionably strong with CET1 ratios all above 11%, but this is already captured in market expectations this year, and beyond this, we’re expecting trends to moderate for several reasons.

Firstly, reporting season also highlighted that the tailwind from higher interest rates now appears to be coming to an end, or at least the end is nigh. The CBA result, in particular showed that monthly net interest margins may have actually peaked last October. Secondly, mortgage growth is slowing, which is a function of the uncertainty in the property market, and in response, banks pricing competition appears to be stepping up as well, and we’re already seeing the big banks offer discounts, and attempt to match competitor’s rights in mortgages, and with a significant cohort of borrowers that are soon to roll off those very low fixed rates that they received over the last few years, particularly as living expenses are escalating, well, we think that’s likely to exacerbate the competitive environment as customers become increasingly incentivized to seek a better rate.

Next, we’re also expecting increased competition and deposits, and that will unwind some of the funding cost gains that the banks have benefited from over the last few years. And we’re already seeing evidence of customers switching out of savings accounts and transactional deposits to higher interest paying accounts.

Fourthly, funding costs arising low cost funding from the federal government’s term funding facility has reduced the bank’s need for wholesale funding, and the majority of this becomes due over the June, September, and December quarters this year, and that’ll need to be replaced with more expensive wholesale funding. Then there’s inflation pressures, which continue to put pressure on the cost base, and people still account for two thirds of the bank’s cost base, so that remains a significant headwind.

And then there’s a question of bad debts. Markets almost become conditioned to a low bad debt environment for the banks over the last decade or more, but asset quality will come under pressure as consumers struggle. And in our view, the risk of high bad debts is rising, and that could be a negative surprise for many. And then finally, there remains the likelihood of increased political scrutiny, particularly as consumers face increased challenges through higher cost of debt, broader increase in living expenses, and also the potential for unemployment.

So we have a double-digit underweight exposure to the big four banks. Overall, we think a quick and aggressive tightening cycle is likely to lead to a weaker housing and mortgage market with the high probability of recession. Our preference is for the business banks over the retail banks. SME competition appears to be contained, relative to retail. NAB remains our preferred exposure. We believe it’s better placed than peers and it’s executing well.

ANZ and Westpac are the value alternatives amongst the big four. They trade at one times price to book and offer gross dividend yields of around 7%. CBA is the better bank, generating better returns on equity and deserves a premium. However, at over 2.2 times priced a book, it’s just too expensive, and its dividend yield at current prices is just 4%. So, overall, we see better risk return opportunities elsewhere and more attractive dividend yields on offer elsewhere, particularly companies that are growing their dollar income over time.

Relative to the banks, we prefer the insurers and we think they provide a meaningful offset to our underweight bank’s position, and our preferred exposures are QBE and Suncorp. Both also benefit from higher interest rates through higher yields on their investment books. Operationally, domestic and international premium rate increases continue to be strong. We are seeing moderate volume growth and benign customer churn. And whilst reinsurance costs are higher claims inflation now appears to be abating. They continue to offer better value. They’re low double-digit PE multiples and attractive dividend yields of over 6%. And in addition, we expect balance sheets to provide capital management opportunities on a two to three year view.