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Becoming expensive (to stay expensive)

The Markets

This week: ASX v Wall Street

FYTD: ASX v Wall Street

A reserved Matt Comyn fronted the market on Tuesday as CBA released its profit result for FY-22.

The numbers presented shed some more light on the dynamics we are seeing in the Australian banking sector and some of the challenges that lie ahead.

While there is a general assumption that rising interest rates are positive for bank profits, there is a growing realisation that this equation may not be so simple.

Why is this important? Well, the big four banks constitute approximately 19% of the ASX/S&P300 Index and have an outside impact on the performance of the market overall.

CBA, in particular, has a high hurdle to jump if it is to meet the expectations embedded in its share price.

We explore why.

The result – competing forces

Three main elements of CBA’s profit result were in focus:

  1. Net interest margins (the difference between interest charged on loans and interest paid on funding sources such as deposits)
  2. Loan growth
  3. Provisioning (profits put aside based on an estimate of future losses)

The underlying loan growth was weaker than the broader banking sector (some 70% of the growth of the sectors as a whole) with CBA ceding market share. The bank decided to pull back on pricing in what has been a competitive environment over the last 6 months. This, in turn, helped keep net interest margins relatively stable. And provisions were largely unchanged, with a small writeback of profits put aside during the post-COVID period when uncertainty was at its height.

The great hope for bank share prices moving forward, as growth in home lending volumes crest, is a rise in net interest margins. There are potential benefits to banks from rising interest rates. The most straightforward being the unrestricted market power that rarely sees higher RBA (Reserve Bank of Australia) rates passed on to everyday savings accounts or term deposits.

Evidence of this can be seen below. Everyday savings accounts have not earned a reasonable rate of interest since 2013 according to RBA data, and the spreads – the difference between the amount charged on standard discounted mortgages and the rates offer for term deposits – has been on an upward rise since 2013 (as seen below).

Source: RBA, First Samuel

Banks also benefit from replicating portfolios (exposures entered into to protect against a mismatch between interest on home loans and on deposits. This effectively reverses some of the mismatch the bank bears i.e. instruments that pay a longer term interest rate and receive a shorter-term interest rate.) and an impending mix change from fixed to variable rate loans.

While the potential benefits are clear, trying to guess what the realised benefit will be is far from straightforward.

An increasingly large proportion of low-rate loans fixed out over the last 2 years (a bargain some homebuyers will not hesitate twice to tell you about) will roll off over the coming year into what is set to be a competitive environment. Comyn did a good job of highlighting CBA’s approximately 35% share of propriety-originated mortgages (loans written directly by CBA, not intermediated by a broker). But as consumers face a 75% increase in interest costs as fixed rate loans roll-off, they are much more likely to pick up their phone and talk to a mortgage broker to get the best deal (a more expensive channel for the banks). The pressure on the banks to “sharpen” their pricing to hold share will be immense.

Furthermore, with funding costs rising, smaller lenders are fighting hard for deposits, potentially putting a damper on the expected “sleepy customer” benefit from banks raising rates but keeping the interest paid on deposits flat. Macquarie’s high-interest online savings account provides a recent an example of the push to attract saver’s deposits.

Therefore, the CBA is between a rock and a hard place.

Barrenjoey’s bank analyst Jonathan Mott put it best in a note this week: “CBA (as market leader) must balance many stakeholders: shareholders, customers, regulators and a new Government. Reprice too far and it risks unwinding the goodwill created through ‘Team Australia’ during the pandemic and opening the door to competition during the fixed-rate refi boom”.

That, of course, is before we begin to talk about what may happen below the revenue line.

We have already seen both NAB and CBA upgrade their expectations, with regard to costs, based on wage pressures and a higher technology spend. If the revenue line does not keep up, these costs will begin to eat into profits.

And the elephant in the room is the chance that in a rising rate environment some loans will go bad. In Jonathan Mott’s estimate, CBA’s share price is implying “a 13% chance of a significant downturn and an 87% chance of a ‘goldilocks scenario’”. Compare this to US banks such as JP Morgan where the probability of a downturn embedded in its share price is 65%. This is in the US, where households are far less leveraged, and the transmission mechanism of higher rates is far less direct (the majority of loans are fixed for 30 years).

Becoming expensive

So, CBA’s outlook for future profit growth is clearly more challenging. Yet remains to be one of the most highly valued banks globally.

Banks normally trade at a price of 1-1.5x their book value in Australia. CBA, meanwhile, trades at a price of 2.4x book, which is “potentially the most expensive developed market bank in the world” according to Jonathan Mott.

Ironically, its chances of remaining so rest on consumers being happy for it to remain their bank choice, despite needing to push its interest rates higher to justify its share price.

Given the strength of its deposit franchise and the heavy retail investor presence on its share register, the loyalty of the public is something CBA clearly isn’t short on. But this will be tested if it is to maintain its share price.

More broadly, the challenges faced by CBA are ones faced by the entire banking sector. Bank share prices are baking in a degree of net interest margin expansion and a relatively benign credit environment.  In our assessment, this presents more downside than upside risk at current prices.

Given this, clients’ positioning in banks remains conservative and has been pared back in recent months.

Company News

Australian Equities sub-portfolio

QBE (positive impact) released its result for the first half of FY-22.

QBE is a large position in client portfolios. We appreciate many of the structural and firm-specific features of QBE, and in recent periods management has reported favourable conditions and improving internal metrics.

As with any global insurer, there was a lot of detail, complexity and moving parts in the result, and this complexity presents risk whenever the company updates.

The result on Thursday broadly exceeded our and the market’s expectations, rising 3 per cent on the day.

If investors are to look for a headline number to assess an insurer’s profitability, a pseudo-gross profit number, it would be the combined operating ratio.

The combined operating ratio represents expenses occurred as a percentage of gross written premium. That is, the percentage of premiums they anticipate they have or will need to spend (be it on claims, reinsurance, operating expense, or commissions) – how profitable their insurance operations are.

QBE’s adjusted COR for FY-22 was 92.9% (thought of another way, an underwriting profit margin of 7.1%).

When we look to why, we can see the benefits of holding an exposure to insurers in an inflationary environment.

Gross written premiums (premiums paid on policies by customers), across the group, increased by 18% (or 13% excluding crop re-insurance). A majority of this came from price increases (or rate), as insurers adjust to an inflationary environment.

These rising premiums not only serve to increase insurer profits on an absolute dollar basis (even if CORs are maintained, they are multiplied by a much larger number), but benefit insurers in terms of the operating leverage they provide.

We can see this in QBE’s result, its operating expenses have increased far less than the rise in premiums it has seen, which has expanded its margins. In the chart below the light grey box represents the expense ratio (operating expenses as a % of premiums written). We can see this has trended downwards as premiums have risen:

Source: QBE

Of course, this is predicated on QBE having adequately priced inflation in its policies. That is, with rising inflation, the cost of claims incurred also rises. With underwriting discipline and a broadly “rational” competitive environment, QBE should be able to price adjust for inflation in claims (and perhaps in some cases more than the potential inflation in claims).

The other aspect to insurance businesses is the money they earn from premiums collected (the float), which they invest into financial markets. These returns also increase in an inflationary environment, as insurers are able to invest in higher-yielding securities. As such, QBE is currently earning 2.5% on its investment portfolio moving forward, significantly higher than the 0.7% it earned just last year.

The combination of higher premiums, lower COR and higher investment earnings bode well for insurers in an inflationary environment, with QBE remaining a core holding.

As a manager that appreciates stocks that are good value, it is important to note that QBE is trading at a ~27% PE discount to the market, which is at the bottom of its historical ranges, despite having earnings risk far lower than it has faced over the past 15 years.


NAB (negative impact) provided a trading update for the third quarter of the year (March to June).

Its third-quarter update was largely in line with our expectations.

However, the bank signalled future cost growth that is higher than previously anticipated, due to higher payroll and remediation costs.

Net interest margins were also relatively flat (likely due to the competitive environment cited by CBA). We still see it as far too early for the impact of higher interest rates to flow through to bank margins, with the market perhaps going into the update with high expectations, given the margin expansion demonstrated by ANZ (whose book is more skewed to New Zealand, where interest rates are far higher).

The combination of short-term concerns, reservations about the consumer and housing market in the face of higher interest rates, along with the issues outlined in the CBA section above, has seen us reduce clients’ positions in NAB throughout the past 6 months.

Property sub-portfolio

Mirvac (positive impact) released its results for FY-22.

The reported results, profits, dividends and its guidance for the short-term outlook were in line with our expectations. The company made 13 cents per share in the current year and, with an expected 10.6 cents per share of dividends in FY23, the stock trades at a reasonable discount to asset value and on a moderate 4.7% yield.

The stock has sold off heavily in the past 6 months in line with the sector due to concerns about a slowdown in residential housing construction and cost inflation headwinds. The financial press is awash with news about the riskiest and most heavily geared construction firms going broke, a cyclical phenomenon Mirvac has witnessed, navigated and grown through over the last 50 years.

The interest for us was in understanding how Mirvac plans to navigate the complexities of the next 24 months, a period in which new capital will be harder to find, and the embedded value in their pipeline of projects will become more difficult to extract.

As such, we were pleased with their plan to divest $1.3bn in assets over the coming year. We remain conscious of the slowing market and ability for MGR to achieve book value and expect proceeds from the asset sales (and capital partnering initiatives) to be deployed into the development pipeline. Execution on the commercial development pipeline, divestments and capital partnering are key catalysts.

We agree with management that this is a time where it is likely opportunities will arise to secure quality property assets and see Mirvac as well positioned for this.

The market responded well to the update, and we see opportunities to increase clients’ currently small positions.

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.

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