while some investors see the decline in bank stocks as a buying opportunity, others are avoiding the sector amid interest rate increases

Fund manager T. Rowe Price remains significantly underweight the Australian banks, and believes their earnings could sharply weaken in the next six to 12 months as slowing growth sparks an increase in non-performing loans.

Baltimore-based T. Rowe, which manages $US1.5 trillion ($2.1 trillion) in assets, is concerned this will offset the benefit that higher interest rates will have on the banks’ net interest margins (NIMs) – the critical gap between the cost of borrowing and lending, a key driver of profits.

“When rate increases go beyond a certain point, the market becomes concerned that there is no benefit to banks from higher NIMs as they get absorbed by worse operating conditions and impairments. And I think we are close to that point now,” said Nick Vidale, equity analyst at T. Rowe Price.

“Higher interest rates also mean funding costs will rise, and we are already seeing increased competition for term deposits, which is negative for NIMs.”

Morgan Stanley also recently cut its exposure to Australian banks in its model portfolio to “underweight”, from an “overweight” position.

The broker said that a quick and aggressive tightening cycle provides more support for margins, but it will also lead to a weaker housing and mortgage market and a higher probability of recession.

Morgan Stanley slashed its price targets on the major banks by an average of 15 per cent, and revised its order of preference to Westpac (overweight), ANZ (equal weight), NAB (equal weight) and Commonwealth Bank (underweight).

Dividend outlook

Another worry for investors is the prospect of flat or declining distributions from the banks, following years of bumper returns through dividends and buybacks.

T. Rowe said it would not be surprised if CBA and NAB suspended their most recent buybacks in light of developing macroeconomic conditions.

“We think there are limited prospects for additional buybacks in the near-term,” Mr Vidale said. “As for the outlook for dividends, we think a good outcome for the banks in the coming years would be if they were able to hold dividends flat.”

However, fund manager Plato Investment Management says financial stocks are still an important element of a diverse equity income portfolio, and bank dividends will remain good sources of income in the short term.

“We don’t expect dividend cuts in the near future,” said Plato’s managing director, Don Hamson. “However, we are less bullish on the potential for further bank buybacks given increased market uncertainty, and the fact that all the big four bought back capital either on or off-market in the past year.”

The firm says investors will receive solid returns from the banks in the next dividend season and, given their share prices have sold off recently, Plato believes their dividend yields look even more attractive.

As for the market’s worries that higher interest rates will increase loss provisions and that a recession is looming, Mr Hamson said those fears were exaggerated.

“Concerns about rising loss provisions are way overdone. Similarly, we think speculation about a potential recession is way too premature,” he said. “Australia has very high employment rates and people with a job usually pay their mortgage.”

UBS believes the major banks were well placed heading into this raising cycle because they carried a total of $15 billion in collective provisions.

“There would need to be a substantial blow-up in credit provisions to derail the Australian banks earnings story,” said John Storey, head of Australian bank research at UBS.

Buying the dip

Citi agreed that the major lenders were well positioned to overcome concerns about a potential deterioration in the quality of their mortgage assets caused by borrowers being hit by the higher cost of living and higher mortgage repayments.

“We find that the current underwriting standards explicitly build a significant level of financial buffer, even for the most leveraged borrowers,” said Brendan Sproules, head of Australian bank research at Citi.

“Also, we find that the banks possess material excess loan loss provisions to cushion any asset quality deterioration.”

Citi maintained its positive view of the banking sector and viewed the sell-off in the aftermath of the RBA’s rate increase as a buying opportunity.

Macquarie also labeled the recent weakness in bank share prices as a “tactical buying opportunity”, noting that the major lenders’ near-term margin outlook was favourable.

“Rising rates and an upward sloping yield curve provide an upside to banks’ margins from improved deposit profitability,” Macquarie analysts said.

While acknowledging that competition for term deposits was intensifying, Macquarie said the banks were benefiting from “lazy” customers, meaning those not chasing special rates offered by competitors.

The broker estimates “lazy term deposits” are one of the most profitable bank segments.

Morningstar also believes that concerns around bad debts for the banks which sparked the sell-off present a long-term buying opportunity.

Leave a Comment

Your email address will not be published.