A view of SA banks

20 April 2017

It is perhaps reasonable to say that leading up to the most recent cabinet reshuffle, most of the local and foreign investors had lowered their expectations for a South African sovereign credit downgrade to probabilities below 20%, and in some cases, to 0%. This was demonstrated in rand strength that tested levels last seen two years ago and the SA 10 year bond yields close to 8.2%.

In this note, we raise what we deem to be short-term, medium-term and long-term risks to the overall sector (without focusing on specific names).

Short-term risks

The risk here lies in the re-adjustment (de-rating) of share prices (valuations). Higher bond yields mean that when one is calculating the shares, a higher discount factor would be used, resulting in a lower valuation. The two charts below depict the current price/earnings multiples of the two banking shares held in the best investment view. Both FirstRand and Standard Bank are trading at multiples below their three year mean (based on 12-month forward earnings). It can be seen that prior to these latest pressures, both these shares were deemed to be fairly valued. Recent price weakness however suggests that (using the same metrics) they are now attractively priced. Moreover, we do not foresee any of the banks needing to cut dividends on a two year outlook (barring Barclays Group Africa, where management has guided for a higher dividend cover ratio). The recent price pressure has meant that dividend yields in the sector now range between 5.5% -7.5%.

 

Medium-term risks

The medium-term risks pertain to the sector’s profitability (earnings sustainability). With the latest downgrades (both S&P and Fitch having rated the country’s foreign currency as sub-investment grade), we are likely to factor in continued deterioration in the rand, higher inflation and flat interest rates with risks to the upside. In such an environment we would expect diminished economic growth as business confidence wanes, placing jobs at risk. For banks, we would closely monitor the top-line growth drivers of Net Interest Income (as advances appetite wanes on the supply side) and Non-Interest Revenues (as deal-making fees and commissions taper off). Impairments would also likely worsen the deeper we move into sub-investment grade, depending on inflation outputs and the South African Reserve Bank response. These are factors we would begin watching for into financial year 2018 results. We expect the sector to remain relatively resilient from an earnings perspective in financial year 2017 as higher prices (fees) are passed on to the consumer.

With the latest downgrades (both S&P and Fitch having rated the country’s foreign currency as sub-investment grade), we are likely to factor in continued deterioration in the rand, higher inflation and flat interest rates with risks to the upside.

Long-term risks

Capital and funding would drive our long-term views around the sector. As it stands, our banks are well renowned for their solid capitalisation profiles. The sector averages approximately 13% on the Common Equity Tier 1 (CET1) scorecard versus the minimum regulatory requirement of 10.375% as at financial year. Needless to say, the sector’s Risk Weighted Assets (RWA) would need to re-price higher following the recent downgrades (not just the country’s lower ratings, but the subsequent downgrades to the specific bank names). While funding is also an important aspect of the longer term assessment of the sector, banks have consistently, in the past, been building up their sources of stable funding and liquidity with minimal adverse impact to margins. We would expect that the sector should be able to pass on the higher costs of funding to the consumer, within reason.

In conclusion, we are comfortable to maintain our current exposures for the moment. Especially given limited clarity and visibility on how events are likely to unfold in the coming weeks and months. As the facts unfold and decisions are reached, we would alter our allocations in-line with our assessment of the investment climate.