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Following the Reserve Bank of Australia's decision to increase the cash rate by 50 basis point in June and July, a slowdown in the property market has been accelerated. According to some experts, shares in the big banks are vulnerable to a slowing housing market. But others say the big banks are undervalued and could benefit from expanding interest rate margins in the months ahead.

Following the Reserve Bank of Australia’s decision to increase the cash rate by 50 basis point in June and July, a slowdown in the property market has been accelerated. According to some experts, shares in the big banks are vulnerable to a slowing housing market. But others say the big banks are undervalued and could benefit from expanding interest rate margins in the months ahead.

A slowing housing market means fewer mortgages will be written. There is also a greater risk of bad debts arising as some mortgage holders won’t be able to service their debts as rates rise; thus, the profits of the big banks could suffer as the central bank is expected to keep raising interest rates this year.

Yet according to Morningstar banking analyst Nathan Zaia, the market is overemphasising the risk of bad debts and the potential for larger-than-expected mortgage losses. Zaia thinks three of the big banks are now trading below their fair value.

“Westpac and ANZ Bank now trade at 30 per cent discounts to our fair value estimates, National Australia Bank at a 7 per cent discount, and Commonwealth Bank 8 per cent overvalued. We have already assumed both slower credit growth and higher loan losses, in comparison to recent years, and while economic conditions have increased uncertainty around both in the short term, we do not believe the share price selloff is proportionate to those risks,” he says. 

Households are sitting on record offset account balances, Zaia says, with about 70 per cent ahead on their monthly repayments, and over 40 per cent more than 12 months ahead. Zaia has a fair value on the Commonwealth Bank of $83, compared to its market price of $91 while the other big banks are trading below his fair values – ANZ’s fair value of $31 is well above its $22.41 price as at 13 July, Westpac’s fair value of $29 is above its $20.06 price, with NAB’s fair value of $29 sitting above its $28.31 price.

Interest margins could widen

Dr Don Hamson, Managing Director, Plato Investment Management, says banks have been quick to pass on the full interest rate rises to borrowers, but not as quick to increase deposit rates, highlighting their ability to expand interest rate and profit margins when official rates rise.

“The financials sector has historically performed well in a rising rate environment, with banks typically able to expand their net interest margins. On the flip side, rising interest rates will likely reduce house prices and loan growth. There has also been speculation that higher interest rates will likely increase loss provisions which have been historically very low,” he says.

“We believe, however, that concerns about rising loss provisions are exaggerated. Similarly, we think it’s premature to be pricing in a recession, Australia has very high employment rates and people with a job usually have the means to pay their mortgage.” Dr Hamson says the big banks have robust balance sheets “and we think this can continue for the foreseeable future”. 

Looking to the upcoming dividend season, investors should get solid income from banks, and given bank share prices have sold off recently, the dividend yield on bank stocks “looks even more attractive,” says Hamson.

Bank asset quality remains strong

A recent report from Fitch ratings has forecast the earnings of the four major Australian banks will remain sound this year, supported by rising interest rates, strong asset quality and the economic recovery, despite high competition, geopolitical tensions and slowing system credit growth.

“The Commonwealth Bank is likely to maintain the strongest metrics in some aspects, such as operating profit/risk-weighted assets, underpinned by its market position and growth execution in recent years relative to peers, even though we rate all four banks at the same level. Westpac and ANZ continue to lag the group in loan growth, but have started to show signs of improvement in the latest results,” said a Fitch report, Australian Bank Earnings Pressure to Ease, but Challenges Remain.

Morningstar’s Zaia is also upbeat on Commonwealth Bank. “CBA trades at a premium to major bank peers due to its track record of earnings and dividend growth, supported by strong organic capital generation. Some market investors consider CBA’s strong emphasis on home loans a weakness, but we argue it is a key strength,” he says.

But not all analysts are so upbeat on the Commonwealth Bank. Consensus ratings from the Wall Street Journal show an ‘underweight’ rating to the Commonwealth Bank; of the 15 analysts surveyed in July, only one has a Buy rating on Australia’s biggest bank while six analysts have a Hold rating. But nine analysts either have an Underweight or Sell rating on the Commonwealth Bank.

Analysts are more upbeat on the National Australia Bank, with seven analysts having a Buy or Overweight rating on the stock out of 15, while another seven have a Hold rating. Just one analyst has an Underweight or Sell rating on the bank.

WSJ consensus forecasts on Westpac are also upbeat: six out of 18 analysts have either a Buy or Overweight rating on the stock, while 10 have a Hold rating on Westpac. Just two analysts have either a Sell or Underweight rating on Westpac. ANZ attracts six Buy or Overweight ratings from 17 analysts surveyed while six have a Hold rating and three have either an Underweight or Sell rating on ANZ.