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The Markets
This week: ASX v Wall Street
FYTD: ASX v Wall Street
It was a busy week in financial markets given the conclusion of the Australian Bank 1H-23 profit reporting cycle and the announcement of the Federal Budget. Our discussion will focus on each in turn.
1/ 1H-23 Australian Bank reporting season – record profits
The Australian major banks have announced their 1H-23 results, which have demonstrated the benefits of a rise in interest rates on their returns.
Qualitatively, this was the strongest set of reported results in several years as well as a record in absolute bank earnings. Bank revenue and profit growth was the fastest level in more than a decade.
Source: Company reports
Net Interest Margin – reversing the downward trend of the past decade
The single largest driver of improved revenue performance for the sector has been the increase in Net Interest Margins.
Source: ANZ
Primarily, the Net Interest Margin (NIM) is a reflection of the difference between a bank’s
- Interest earned on loans and other securities; and the
- Interest cost paid on customer deposits and borrowings from wholesale markets
At a time of rising interest rates, a bank’s NIM benefits from earning a higher absolute yield on its assets while (a) continuing to pay very little interest on transaction/cheque accounts throughout the cycle and (b) not paying interest on the Equity that is required to support its balance sheet.
Major Bank Future Share price drivers
Despite record returns and growth rates, share prices for the sector have generally softened at the time of results announcements. We consider two main factors behind this.
a/ Peak Net Interest Margins and consequential slowing revenue growth
On the asset side of bank balance sheets, mortgage credit growth has been moderating (due to higher borrowing costs for consumers and falling house prices). This in turn has driven banks to compete more aggressively in the market for new business. This has come via increasing loan pricing discounts to Standard Variable Rate as well as ‘Cash Back’ offers encouraging consumers to switch banks.
Source: NAB
On the liability side of balance sheets, Australian banks have been competing more actively for deposits in an effort to replace the incredibly low-cost Term Funding Facility, which was provided to them by the federal government during Covid.
Accordingly, this has resulted in pressure upon Net Interest Margins
“We saw margins peak in October on a month-on-month spot basis” Matt Comyn, CEO, CBA 1H-23 result.
“…continued industry-wide pressure on mortgages, particularly retention discounting and the impacts on funding costs as banks looked to replace the TFF has meant that we expect a decline in NIM in the second half” Patrick Allaway, CEO, Bank of Queensland 1H-23 result.
b/ Credit costs are expected to continue to rise from a modest level
The unwinding of excess Covid-related impairment provisions has now passed, but bad debt charges remain below ‘cycle average’ levels.
Source: Commonwealth Bank
We’d anticipate that as the fixed rate ‘mortgage cliff’ impacts household cash flows (most notably in the next 6-12 months) that (a) the level of mortgage arrears and, perhaps more substantially, (b) the flow-on impacts upon small and medium enterprises will lead to rising credit losses and be a source of declining returns for banks.
Source: Commonwealth Bank and Westpac Banking Corporation
While customers on variable rate mortgages would typically be facing a 25% lift in their mortgage repayments as a result of the underlying increase in cash rates, for fixed rate borrowers who took cheap loans out over Covid, more than half of these customers will face an increase in repayments of greater than 50%.
Source: National Australia Bank
Summary – remaining cautious on the outlook for major bank share prices
First Samuel clients remain substantially underweight shares in the bank sector, including all the 4 Majors, in their Australian equities’ sub-portfolio.
While there have been tactical moments when an increased weighting in bank shares has been advisable, bank shares have comfortably underperformed the broader index over the past eight years. We remain vigilant for opportunities to tactically add bank shares to portfolios, but remain generally unenthused about the outlook over the next 6-12 months.
Macquarie Bank
Amongst the activity of the major bank reporting season, Macquarie Group also announced its FY-23 result.
As a large portfolio position, we were pleased to see another positive earnings and dividend surprise, beating consensus estimates by 5%, while growing net profit by 10% yoy and dividend by 21%.
The star performer amongst their business segments was the Commodities and Global Markets division, which accounted for more than half of Group revenues in FY-23 and delivered a greater than 50% uplift in profit contribution.
This business seems unlikely to be able to replicate such a result in the coming year, with less conducive conditions in energy markets, where the business has taken advantage of increased volatility in gas markets in Europe and North America.
While near-term earnings may retrace a little after a stellar three years in which the Group earnings have doubled, we still believe that the medium-term outlook for the business remains very strong given the quality of people, level of investment and strength of market position in
- Energy and Commodities Markets
- Infrastructure Asset Management and Advisory
- Australian Retail Banking
2/ A Budget of Missed Opportunities
There are mountains of material written on the Federal Budget, not to mention hours of footage and a proliferation of (mis)information on social media.
This review will attempt to provide Investment Matters readers with a perspective on the Federal Budget that is closer to the way markets and economists, with a long-term outlook, may assess individual elements.
Consequently, we consider that the measure of a budget is not this year’s or next’s ‘winners’ or ‘losers’ or whether it is in surplus or deficit.
It is the effect on long-term economic growth by its three critical drivers.
It may be a simple mantra – but there are only three elements of long run growth: the three P’s.
People, participation, and productivity.
Unfortunately, both sides of politics love the first – population growth abounds; and the second: both are interested in and have actively supported increases in labour force participation. However, both do not really require heavy lifting.
However, we would argue neither side of politics is willing to commit to productivity improvements.
This budget does nothing for productivity (neither did many of the budgets of the former governments).
As the former government’s Intergenerational Report noted, for 30 years until 2019 productivity growth averaged 1.5% p.a. Since then, it has been 1.2% p.a. Getting it back to 1.5% p.a. would provide a massive and enduring boost to growth.
For example, the budget’s once- off subsidies for electricity charges reduce productivity, they reduce investment in energy transition and demand changes at the household level. The social equity considerations that many drive the electricity subsidies would be better achieved through an earned income tax credit, or reform to social security payments.
The electricity subsidy to small business could have been converted to an increase in the amount of instant asset write off or changes in R&D and training support. Why would two small businesses, one growing and investing and the other partially defunct and stagnating, get the same support?
Interestingly some of the measures designed to raise revenue were (unintentionally?) productivity enhancing insofar as they help eliminate excess economic rents or move cost recovery closer to the activity that creates them. This includes improvements in Petroleum Resource Rent Tax, higher tobacco excise, and visa movement charges. The scope for further changes of this type, especially if they can be used to limit the expansion of health or aged care costs will be critical.
What drove the surplus in FY-23 – and why was this a surprise?
Now, back to the easy bits. At its simplest, Treasury was too pessimistic on the economy in FY-23, and this pessimism led to the previous Budget under estimating income and overestimating payments. The FY-23 budget deficit was expected to be $36.9 billion – but income was $28.2 billion higher and payments $13.9bn lower, so when combined with limited policy changes the Budget moved to a small surplus of $4.1 billion.
Treasury expects some influences over the past year to continue over next 5 years. As a result, the Budget position over 5 years has improved by a cumulative $146.5 billion, driven by stronger actual and expected wages, higher employment levels and the short-term spike in commodity prices. Around one-fifth of the increase in tax receipts reflects changes to assumptions on the path of commodity prices in response to sustained high prices.
Ultimately, whilst Treasury has slightly increased their long-run prices for iron ore and coal they share our view that prices for those commodities will almost halve over the medium term. The chart below shows the current forecast of budget deficit as % of GDP versus last year’s path of forecasts in red.
Source: Australian Government, UBS
The reduction in budget deficits have also led to a reduction in future interest payments in a virtuous circle.
Why do some suggest the Budget isn’t sustainable?
Sustainability can be a simple political perspective, conservatives may suggest budgets are meant to be balanced, others, that Governments simply need to be able to service the debt into the future. More radical views may question the validity of limiting budgets beyond what is required to sustain employment and government services.
Regardless of the political perspective most would agree with the distinction between cyclical components of a budget and structural components. The chart below shows how the Budget has evolved over the past decade along with a decade of current forecasts, breaking down components of the budget. Structural factors include defence, NDIS, aged-care and fixed payments to states.
The chart shows that despite our enormous good fortune as a nation, with energy, iron ore and lithium price strength, we have now committed ourselves to a moderate and continual structural deficit. The only possible offsets being increases in productivity, further improvement in the terms of trade (mainly commodity prices), or reversals of planned structural spending.
The chart below shows the higher structural deficit has been driven by core policy changes in aged care, NDIS, along with the increase in interest costs payable on the measures funded through the COVID crisis.
Whilst the deficit is not problematic for the Australia economic outlook, it does represent a critical intergenerational issue. Most structural tax benefits accrue to older Australians, much of the structural deficit is spent on the same population, and the vast majority of assets in the economy are owned by the same cohort. Yet taxation remains concentrated in PAYG workers, consumption taxes, and net company taxation (after franking credits) held in the superannuation of existing workers.
Additional factors which are likely to continue to see the structural deficit grow will include further defence spending, the failure to rein in the NDIS cost growth or additional support for heath.
What does the market and equities like about the Budget?
The reduction in deficit in FY-23 and the improvement in the outlook created a significant change in the outlook for Gross Debt compared to a year ago.
What does the market and equities like about the Budget?
The reduction in deficit in FY-23 and the improvement in the outlook created a significant change in the outlook for Gross Debt compared to a year ago.
Source: AOFM, Australian Government, UBS
The value of financial assets, including equites and credit are supported by the chart above.
The improvements in the outlook for gross debt to GDP points to an economy that has a balance of activity between government and private enterprise. The overall level of debt (<40% of GDP) points to a government with enough capacity to support the economy through any, currently unanticipated, economic slowdown. The government isn’t as well placed as it was pre-COVID, but there is still capacity. This capacity is vital, as the government remains a critical investor in the transition of our economy, providing the funding for the infrastructure required to sustain the higher population growth and remains an important supporter of the financial system in periods of liquidity constraints.
The Budget impact on household purchasing power over the next 12 months.
Despite the headlines such as power relief, reduced out-of-pockets for medical, and previously announced childcare changes, the removal of the Low & Middle Income Tax Offset more than reverses any benefit.
The electricity and medical subsidies reduce inflation but in combination with offset removal, there is limited stimulus.
In summary
The Federal Budget was broadly neutral to slightly positive for equities markets, and First Samuel agrees with many commentators that this year’s pronouncement follows a long tradition of missed opportunities and squandered windfalls.
Considering the tradition is nigh on 30 years old, the only mistake would be to assume something different!
The information in this article is of a general nature and does not take into consideration your personal objectives, financial situation or needs. Before acting on any of this information, you should consider whether it is appropriate for your personal circumstances and seek personal financial advice.