With the banks collectively trading at five-year lows around 30% from the 2015 highs, given the extreme negative sentiment around the sector, it is natural to question whether we are at “peak negativity” as the banks report over the next week. The sector is cheap relative to both historical levels and the broader market, but with the FY18 results approaching, will they be enough of a positive catalyst catalyst to drive a re-rating throughout the sector?
Margin Pressure: Margins are likely to have declined throughout the second half of 2018 due to the increased cost of wholesale funding and lending spreads. Looking ahead to 2019, margins should be maintained as the out of cycle rate increases offset the rise in funding costs. The BBSW/OIS spread has stabilised from higher levels seen earlier this year and term deposits spreads across the majors have narrowed thus reducing competition, which should also help support margins in the first half of FY19.
Remediation/Restructuring Costs: Customer remediation expense provisioning as a result of the Royal Commission will continue into FY19, reducing profitability. One-offs items, customer remediation expenses and restructuring costs will be a focus of the results over the next week further pressuring the subdued earnings environment.
Loan Growth: Loan growth will be pressured by the decline in the housing market and tighter regulatory standards. These headwinds could be marginally offset by business lending growth. Without growth the investment thesis remains pressured, especially against the backdrop of increased regulatory scrutiny and cost pressures.
There is no doubt consensus surrounding the banks is very pessimistic so the bar to surprise on the upside is low. However, with so much uncertainty on the sidelines pressuring earnings until further clarity on all or some of the below emerges, it will be difficult for the sector to enter a broad upgrade cycle:
• The Royal Commission final report due Feb 19
• Further announcements of customer remediation expenses and restructuring costs
• Removal of policy uncertainty surrounding franking credits and negative gearing emerging from the outcome of the Federal election (latest May 19)
• Deceleration in decline of East Coast housing market. Whilst not the most significant pressure the negative sentiment surrounding the housing market will leave the banks victim to offshore selling.
With these challenges facing the sector in mind, coupled with the expectation of messy FY18 results, it is unlikely the updates will be enough of a positive catalyst. But despite the negatives, strong capital positions across the Big Four will reduce the likelihood of dividend cuts and with an average gross dividend yield of 9.8% further downside should be limited.