4 key issues for bank shares in 2017

4 key issues for bank shares in 2017

The outlook for Australia’s banks in 2017 is now tougher given the rerating of the stocks the last quarter of 2016. The expectations built into share prices have clearly lifted in 2017.  The big change we expect is a slowing of loan book growth. If interest rates have bottomed, affordability of debt will suffer. Market expectations imply a continuation of the growth rates we’ve seen over the past decade or two, but if the cost of debt stops falling this could act as a drag on loan book growth and the broader economy. Funding costs continue to rise, pressuring net interest margins. Slowing loan book growth is also likely to increase competitive pressure as banks look to gain market share as an offset.

Non-interest income remains challenging and is likely to remain flat or achieve anaemic growth. Cost cutting will be a focus, but this is made more difficult on a net basis by the accelerating need to invest in technology. We don’t think this challenged outlook for earnings is currently reflected in bank share prices.

Events and data to watch

There are four key areas to watch in 2017. The first is loan book data from the RBA and APRA as this is one of the main drivers of bank earnings growth.

Second, the Basel 4 regulations should be released in the first half of the year, with APRA’s draft recommendations to follow. Once this happens, we should have greater clarify on the amount of regulatory capital the banks will be required to hold, and well as other regulations that could impact margins.

Third, the question of funding mix and maturity profile will be important for net interest margins. We’ve already seen a shift away from short-term wholesale funding towards longer-dated issuance, which has a higher funding cost. This higher cost is then passed on to mortgage and business loan rates.

Finally, asset quality and business conditions. Non-performing loans (NPLs) are close to cyclical lows, but we are heading into a construction downturn from the current peak levels. This will impact economic growth in the eastern states. If economic growth starts to stall, you’re likely to see an increase in business, commercial, and personal loans before it begins to affect mortgages. If NPLs on mortgages rise significantly, it will be much more serious due to the larger scale of the mortgage books.

Preferred exposure

We prefer the higher quality banks that can sustain higher returns on capital, which means Westpac and CBA. However, as the growth outlook diminishes, the value of the premium on that higher return on capital falls. Although Westpac and CBA have a larger proportion of their loan books in mortgages, the averages fail to tell the whole story. It’s important to consider other risk factors such as the level of exposure to high LVR (loan to value ration) loans, the age of the loans, and the geographic location.

At current levels, we see all the banks as being similarly expensive.

This article first appeared on Livewire. Read here.