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[Editor’s note: Do not read the following analysis as a recommendation on the banking sector. Like all stocks, banks have risks. For example, a downturn in the economy can lead to an increase in bad and doubtful debts that could affect bank earnings and dividends. Do further research of your own or talk to a licensed financial adviser before acting on themes in this article].

As Chief Investment Officer at Clime Investment Management, having a view on the Australian banking sector, and more specifically each bank stock, is essential because nearly every individual we advise, or portfolio we manage, will hold an Australian bank stock.

Moreover, while the Australian banking sector is a smaller percentage of the sharemarket than it once was, if you are hold an S&P/ASX 200 Exchange Traded Fund or index fund, around 20% of your invested capital will be spread across the big-four bank stocks [based on S&P Global data].

Clime’s investment view on the Australian banking sector does not only reflect our fundamental outlook for banking stocks. It also colours our view on the fundamentals of the Australian economy. The strength of the Australian banking system is paramount to the future stability and growth of Australia’s economy.

The post Global Financial Crisis (GFC) period (after 2009) has seen a material increase in the use of credit as the primary transition mechanism to drive global economic growth. As central banks have expanded their balance sheets, the banking system has played an integral part, ensuring those funds make their way to companies and individuals, to fuel economic growth and advances in living standards

As such, with central banks set to reverse course with the end of quantitative easing (a form of monetary policy), are banks positioned over the next 3-5 years to deliver growth in earnings and more importantly, dividends to shareholders, when interest rates rise?

Bank outlook

To understand the outlook for banking stocks, we review three key drivers of earnings:

  1. Growth in loan volumes (credit growth)
  2. Net Interest Margin (NIM)
  3. Expectation of credit losses, otherwise known as Bad and Doubtful Debts (BDD)

 

1. Growth in loan volumes

Fundamentally, Clime is positive on the outlook for the Australian economy, given our expectation of continued high commodity prices supporting our terms of trade and the return to normal levels of migration adding to economic growth (Gross Domestic Product).

This positive outlook on the economy underpins the view that GDP growth will be funded by credit growth, with recent housing credit being supplemented by a period of investment from the Australian corporate sector, whose capital position is extremely strong.

Simply, Clime believes the Australian banking sector will continue to see stable growth in mortgage lending, with accelerating growth in business loan volumes as companies invest after a period of low capital expenditure. In the chart below we can already see this trend of higher lending.

2. Net Interest Margin

Net interest margin (NIM) is the difference between what a bank is earning in interest on loans compared to the amount it is paying in interest on deposits. 

A bank borrows through a mix of loans from other institutions and banks in domestic and international credit markets and closer to home through term deposits. While the interest rate a bank will charge is broadly dictated by the Reserve Bank of Australia (RBA), the actual interest rate charged is set by the bank itself and reflects those funding costs and competitive dynamics. 

So, the key question is: what do higher interest rates mean for the banks’ NIM? While higher interest rates are not what a mortgage holder wishes to see, this has a positive impact on a bank’s NIM and is thus positive for bank earnings and dividends, in Clime’s view. 

[Editor’s note: Although important, a bank’s Net Interest Margin is one of several factors that influence growth in bank earnings and dividends.]

 

3. Bad and doubtful debts

However, Clime’s positive thesis on the banking sector is primarily applicable to the early stages of a rate tightening cycle, as the economy continues to grow and as a low employment rate drives wages higher.

As stated in our view on credit growth, Clime believes the Australian economy is well positioned to grow over the next period driven by an expanding corporate sector and higher commodity prices.

While we don’t envy the complexity of the central banker’s job, history has shown us that it is extremely difficult to get the balance right between higher interest rates and sustainable economic growth. As we near the end of a rate cycle (rising rates), as economic growth slows, undoubtedly some debts won’t be paid back in full. To reflect this risk, banks have a Bad and Doubtful Debt (BDD) charge as an estimate of a percentage of loans that will not be repaid.

During the COVID-19 period, the extraordinary stimulus and support to the Australian economy meant that bad debts were far lower than expected, and consequently banking stocks were able to “write back” the value of earnings that they had expected to lose.

Conversely, as we now move into a rate hiking cycle, the risk is that bad debts will increase. Clime believes a combination of high current savings, a strong economy and likely wage growth will result in mortgage stress remaining benign for the next 2-3 years.

However, the significant debt held by households means that the economy is acutely sensitive to higher rates, as the RBA is itself fully aware. For now, we believe the risk of higher bad and doubtful debts is finely balanced, supporting the benefits of solid credit growth and higher NIMs for Australia’s banking sector.

 

Conclusion

In a post COVID-19 environment, Australia’s banking sector is positioned to deliver growth in earnings and fully franked dividends, in Clime’s view.

While we are ever watchful of the impact of higher rates on a leveraged housing market, we believe the positive outlook for the Australian economy will support continued lending growth, powered by investment from the corporate sector.

Moreover, while we do not expect to see the repeat of the near perfect conditions for banks in the early 2000s, we believe the banking sector has solid long-term prospects.

In the context of heightened global uncertainty, the ability of bank stocks to deliver a growing dividend stream will be increasingly important.

[Editor’s Note: Clime’s view on banks relates to the sector. Individual bank stocks could perform differently to the top-down view that Clime has outlined.]

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