According to Morningstar Equity Research, Australian banks are well capitalised, profitable, and highly regulated. They are generally undervalued and set to benefit from higher rates1. Low rates underpinned strong credit growth in recent years, with total system loans up 18% in the three years to February 2023. With higher interest rates and inflation reducing borrower capacity, and falling house prices hurting investor confidence, we expect low-single-digit credit growth in the medium term2. Growth slowed to an annualised rate of 3% in the last three months2. Households drawing down on savings to meet higher mortgage repayments could aid credit growth2. Offset account balances at the big four banks reverting to 2019 levels would add 2.5% to major bank home loan balances2.
Higher Margins to Drive Earnings Growth
Banks passed on rate increases to existing borrowers in full. With customer deposit rates, a large part of funding, on average rising less, margins are up from compressed levels in the last half. But intense competition to retain customers as fixed rates mature and borrowers seek savings sees widespread discounting. We still expect banks with large loan books to benefit from higher rates2. Once customer switching eases, we expect banks to reprice loans and discount less to deliver return on equity above our 9% cost of equity. This is expected to be driven by wide-moat-rated major banks2.
Regulatory requirements on capital, liquidity, interest rate risk hedging, and lending standards give us comfort that highly profitable Australian banks will not face issues like those behind the banking crisis in North America and parts of Europe2. Falling house prices and borrowers facing a more than doubling of interest repayments increase loan loss risks. But we think bank balance sheets are sound. We gain significant comfort given loans were made with a 3% serviceability buffer, labour and rental markets are tight, and equity buffers and bank provisioning are substantial2.
Australian Banks Undervalued on Short-Term Margin and Bad Debt Uncertainty
The Morningstar Equity Research team put Westpac and ANZ Bank as the best value among the majors. Commonwealth Bank remains an expensive outlier given industry leading return on equity, cost/income ratio, net interest margins, and market share. (Data as of April 4, 2023.) Bank of Queensland shares fared better than nonmajor peers in the quarter, but the removal of the CEO last year still weighs. Earnings uncertainty has risen, but the market appears too pessimistic on loan quality and costs. MyState shares price in declining home loan balances and compressed margins, but we think earnings growth will be underpinned by the small lender taking market share.
Dividend Yields Attractive Despite Much Improved Term Deposit Rates
According to the Morningstar Equity Research report, the divergence in valuation between Commonwealth Bank and peers Westpac and ANZ Bank is stark, and in their view, unjustified. Price/book discounts are likely to unwind as the banks deliver earnings growth and stem market share losses. After resetting dividend payout ratios, they think dividends can be maintained and grow in line with earnings. Share price weakness in most of the nonmajor banks relative to the majors has pushed dividend yields to very attractive levels. Nonmajors have more expensive customer deposit funding, but they think margin downside risk is overdone1.
Higher Rates To Slow Housing Credit Growth
According to the Reserve Bank of Australia, trailing year housing credit growth was up 5.8% to end-February 2023, down from the May 2022 peak of 8%. Rate increases have slowed demand, with February 2023 owner-occupier housing loan growth up just 0.23% month on month, or just 2.8% annualised1. Nonbank lenders are small but held share of total credit steady at 8%. We think major banks should make modest share gains in a higher rate environment, as nonbanks grapple with higher funding costs and a potentially higher risk loan book, with larger exposure to self-employed, low documentation, and high debt/income borrowers2.
Morningstar Equity, Industry Pulse April 17, 2023; Australian Banks: First Quarter 2023