While equity analysts at Morgan Stanley are warming to the materials sector, upgrading both BHP Billiton and Rio Tinto to an overweight rating overnight, they remain cool on the outlook for Australian banks.
In a research note out today, the bank has retained its negative stance towards Australia’s largest banks, seeing downside risks from rising loan losses, higher funding costs and an increased probability of dividend cuts.
“We see downside risks to our base case, which assumes mid single digit volume growth, steady margins, a modest loan loss cycle and flat dividends”, say Morgan’s.
“The Australian economy has not faced this many challenges for 25 years, and the regulatory environment is also getting tougher. We think investors now need to focus on the prospect of rising loan losses, higher funding costs, and dividend cuts.”
On the first downside risk they see – rising loan losses – Morgan’s suggests that the risk of a recession in Australia is growing as regulators attempt to achieve a difficult soft landing in the housing market amidst external and internal challenges.
Analysts at the bank note that the banks have benefited from an extended period of asset price reflation since the global financial crisis, which has driven impairment charges to incredibly low levels that will be hard to sustain.
“A combination of improving credit quality,collective provision releases and elevated write-backs has driven impairment charges to bottom-of-the-cycle levels,” they note.
However, we forecast them to rise from 16bp of loans in FY15E to 21bp in FY16E and 28bp in FY17E. As a result, an earnings tailwind of 4% in FY13 and 5% in FY14 becomes a headwind of 4% p.a over the next two years.”
Morgan’s also see risks of funding costs for banks increasing due to net stable funding ratio (NSFR) requirements that will be introduced in 2018.
“This suggests that banks will need to replace short term funding with long term funding and at call deposits with term deposits, while increased competition could drive up the cost of deposits.”
“Our sensitivity analysis shows that wider spreads on new term wholesale debt issues do not have a material impact on banks’ earnings, but every 25 basis point increase in the cost of term deposits reduces group margins by an average of 6 basis points and lowers earnings by 4%,” they note.
On the third key risk they see for the sector – cuts to dividend cuts, Morgan’s offers some food for thought for yield-hungry bank investors.
“In our view, payout ratios are elevated and will need to be revised lower, but this can be managed over the medium term, so we forecast a period of flat dividends,” they state.
“However, we think the risk of dividend cuts is rising and is more likely to be driven by the credit cycle than by changes to capital requirements.
Morgan’s believe reducing dividends will be viewed as a “last resort” by bank board members.
“Our scenario analysis suggests that the “grey area” emerges when loss rates rise to 45bp of loans and EPS downgrades reach 10%.”
In response to the perceived downside risks, Morgans sees CBA and NAB as equal-weight prospects. They are underweight towards Westpac and ANZ, forecasting declines share price declines of 6.5% and 7.1% respectively as of the close on October 6.