Why SA bank shares
will withstand the European whirlwind
Fears of a retreat to the dark days of the 2008 financial crisis has investors running scared. Just as South African banks were recovering from the thrashing they took after the firing of Nhlanhla Nene as the country’s finance minister, it looks like all bets are off again.
The FTSE/JSE banks index fell 13.5% on December 10 — a day after Nene was removed from office. It tumbled a further 6% the next day, before stabilising in the last days of 2015 as Pravin Gordhan’s reappointment soothed the markets. Nevertheless, by mid-February, the banks were still trading below pre-Nenegate levels.
Of course, it can’t all be blamed on local politics or on the looming threat of a sovereign downgrade. Fact is, it’s been a torrid start to the year for banks across the globe.
The STOXX Europe 600 Banks index had lost a fifth of its value by early February. Concern over the strength of balance sheets, exposure to the weakened resources sector, zero to negative interest rates and a general risk-off mood has brought a shift out of equities into gold and top-rated debts. And banks have borne the brunt of this sell-off.
“Clearly, were there to be a collapse of any global systemically important financial institution, that would have repercussions way beyond what anybody can anticipate,” says Chris Steward, head of financials at Investec Asset Management. “SA banks comfortably navigated the previous crisis, and would do so again [if another one occurred] as they are in better shape now than they were then in terms of capital, provisioning and the quality of their balance sheets. But it would nevertheless have a ratings impact on financial services companies [globally].”
This sour mood is why, despite the recent sell-off, analysts aren’t predicting any big recovery in share prices anytime soon. Of all the JSE-listed banks, Investec is the sweetheart right now. All 9 analysts polled rate it a “buy”, putting a target price of R130.57 on Investec PLC — 28% above its current levels of around R101.
Of the big four retail banks, FirstRand and Barclays Africa seem to be the favourites.
FirstRand has eight “buys” and seven “holds”, though the target price it expects for the stock is R46.37 — just 1.6% above its current level. Barclays Africa has an even split of seven “buys” and seven “holds”, but the target price is R151.31, just 0.8% above its current R150.15.
Nedbank has six “buys”, eight “holds”, one “sell” and an expected target price of R199.55 — 4.5% above its current level. There’s less optimism about Standard Bank, with analysts roughly split, and just a 1.9% upside on the target price.
But if the mood darkens in Europe, and globally, even these predictions may prove to be too optimistic.
The main issues in Europe include lower than foreseen earnings, largely because European interest rates are now expected to stay lower for longer.
This will keep bank margins depressed, says Nedbank CEO Mike Brown.
Throw in the fact that weak commodity prices have put pressure on oil-dependent countries, and you have all the makings of a horror show.
Many of these countries borrowed from global banks when oil prices were north of US$100/barrel. Today, with oil prices ebbing at around $30/barrel, banks are facing the risk of rising impairments and defaults. There is now speculation that a small number of European
We would not expect a European bank, and certainly not a large one, to fail in the current environment
banks may not be able to repay their coupons on new-style Alternative Tier 1 capital instruments. These instruments include Contingent Convertible bonds, known in shorthand as CoCo bonds. They’re not new, but they suddenly have investors very worried indeed.
CoCo bonds have been widely used in Europe to boost capital to meet the stricter requirements since the 2008 crunch. They work by having discretionary interest payment clauses, so that interest can be withheld. Bloomberg describes them as high-yield investments with “a hand grenade attached”.
CoCo bonds are almost a cross between a stock and a bond, but they can also be converted into equity in the issuing bank. It’s risky business, but in a yield-hungry world and with developed-world interest rates offering little, there has been enough uptake to cause concern.
In SA, only Investec of the big five banks has issued an AT1 instrument, but fortunately for them, it’s not a CoCo bond.
Nedbank’s Brown doesn’t think there’s reason to be too worried, however. “We would not expect a European bank, and certainly not a large one, to fail in the current environment,” he says. “This is due, among other things, to the implementation of the regulatory enhancements since the global financial crisis.”
Steward agrees that banks’ balance sheets are generally in better shape that they were before the global financial crisis, even if investors are still taking a dim view of future profitability.
“There are concerns about the environment they are operating in and their ability to generate decent returns,” he says. “There are also concerns about what is going to happen to monetary policy globally.”
But even if a smallish European bank were to go under, Brown says, there should be very little direct spillover into the SA banking system.
Nedbank’s exposure to banks in Europe is generally through excess funds placed overnight with systemically important banks in investment-grade sovereigns. Brown says that these counterparties are reviewed regularly and exposure is of a short-term nature.
Steward says SA banks are in a somewhat different space from their developed-market peers. They are better matched, in the sense that they source their funding in the short-term market and also lend off relatively short-term reference rates.
“We are in a different monetary regime, with rising interest rates which, while possibly positive for margins, will have a negative effect on credit quality,” he says. “The biggest concern is that the SA Reserve Bank might be forced into a series of defensive rate hikes to protect the currency and prevent the second-round effects of currency weakness on inflation.”
While interest rate hikes are positive for banks’ margins, the danger is that they could lead to a sharp drop in credit quality.
A 100 basis point hike in interest rate this year would probably be manageable, but Steward says more than that would be bad for the banks.
“There is no doubt they are in a tough space; this is going to be a difficult year,” he says.
Unlike some other analysts, Steward doesn’t believe banks are particularly cheap at current valuations. Rather, he says the market’s expectations for earnings growth for this year remain too high. “Market forecasts appear to factor in earnings growth of about 10% this year, but I think the banks will do well to produce flat earnings,” he says. “I worry that expectations are still too elevated.”
With banks generating returns on equity in the mid teens — around the same levels of investors’ cost of capital — he says valuations of 1.5 times book value aren’t particularly enticing.
“They have reasonably attractive dividend yields, which in most cases are probably sustainable to within 10%,” he says. “If earnings do go down, then dividends might too, with the exception of FirstRand and Standard Bank, which have decent capital buffers they could dip into.” A sovereign downgrade would be negative, but Steward says SA banks have an advantage over their emerging-market peers as their balance sheets are largely rand based, with little foreign currency exposure.
SA banks also don’t have the same sort of exposure to commodity prices as their European counterparts. Harry Botha, a banks analyst at Avior Capital Markets, reckons only 2% to 5% of the assets of local banks are exposed to commodities. While this suggests they’re still likely to face some credit losses in the next few years, Botha doesn’t see this reaching crisis levels.
“In the global financial crisis, the big four SA banks’ income statement credit losses were more or less double 2015 levels,” Botha says. “We estimate this is priced into banks’ share prices and because we do not expect credit losses to this extent we find SA banks cheap at current levels.”
Cheap maybe — but that’s for a reason, says Paolo Senatore, chief investment officer at Ashburton. He says: “The South African consumer is likely to come under pressure.” Investors have become quite used to banks reporting growth of 15%-20% in earnings per share, but this is more likely to be around 8%-10% in future, he says. “So, while a price:earnings ratio of 10 looks cheap, it’s reflecting earnings for the next year or so.”
The best-case scenario for the worst-rated banks such as Barclays Africa and Standard Bank, says Steward, would be if government does all the right things from a policy perspective, the markets resume a risk-on rally and the cost of capital starts to fall. But in a tougher environment, Steward would stick to the likes of FirstRand. While FirstRand might trade at a higher multiple, it generates superior returns, has a more conservative balance sheet and is better capitalised.
Avior’s Botha prefers Standard Bank and Nedbank on a total return basis.
But, if you’re after the lowest commodity exposure with a reasonable return, then FirstRand would be top, he says.