Limited downside risk to local financial sector
The barrage of negative events from pandemic to a contracting economic growth in 2020 points to an uninspiring narrative for the local financial sector. Local markets have recovered from March lows on the back of the stimulus support provided by policymakers.
The crooked V-shape recovery can be seen in both the financial and main index, with the former trailing the latter. This week, we look to share some of our thoughts on the financial sector and its prospects moving forward.
In efforts to mitigate Covid-19’s impact, Bank Negara Malaysia (BNM) has eased interest rates in each of its Monetary Policy Committee Meetings this year.
While a lower interest rate may spur loan growth in the near term, it may also impact the banking industry’s net interest margins (NIM).
NIM is the difference between interest-earning assets and interest paid to their lenders. In the uncertain times ahead, we expect the banking industry to face further NIM compression.
Other expenses, such as nonperforming loans will also stack up to affect margins. For the past decade, banks have experienced decreasing non-performing loans (overdue loans for more than 90 days), likely from better usage of customer data in filtering out subprime borrowers.
During the current outbreak, the loan moratorium could help to alleviate some burden off businesses’ hands. Taking into account possible downside risks from companies facing bankruptcy issues, we expect non-performing loans and bad debt provisions to increase mildly. The full impact will likely come to light in 2H20.
Consumers may hold back on spending
Since the easing of social distancing measures, economic activities have picked up on the local front, albeit at a gradual pace. Many consumers are still being cautious to avoid the risk of being infected, and the poor job markets have steered investors to hold back on their discretionary spending.
As there is still uncertainty surrounding the virus and the timeline of economic recovery, consumers have been increasing their savings to buck up for any unforeseen circumstances ahead. A cautious consumer market may not bode well for banks, as credit demand relies on consumers to have an appetite for discretionary spending.
While the situation may be unfavourable to the banking sector, strong balance sheet numbers suggest banks’ ability to weather through this challenging period. Total Capital Ratio and Tier 1 Capital Ratio are in a healthy region of 18 per cent and 14 per cent.
According to the Basel III Acord on bank regulation, the recommended ratios that banks must maintain is 8 per cent for the Total Capital Ratio and 6 per cent for the Tier 1 Capital Ratio.
This shows that the banking system has much higher capitalization ratios than what is required and thus better positioned to withstand macroeconomic and financial shocks.
Limited downside risk from further foreign outflow
As various stakeholders live with the new political norm ever since the 14th general election, the political scene in 2020 has unfolded in ways unimaginable by most, such as the resignation and the appointment of the seventh and eighth prime ministers respectively.
The renewed political uncertainty has injected a dose of risk premium to foreign investors’ evaluation of local equities.
Nonetheless, while political uncertainty may still be present, downside risk from further foreign net outflow may be limited given the huge net outflow so far in 2020.
Taking a look at some of the largest banks in Malaysia, the foreign shareholding of Maybank and CIMB are at 25.6 per cent and 17.4 per cent respectively, below their historical average of 33.2 per cent and 19.7 per cent for each bank.
The recovery for the past few months has brought valuations of the Bursa Malaysia Finance Index to hover around -1 standard deviation levels. As of 23 June 2020, the Index’s earnings growth for FY21 and FY22 are 11.4 per cent and 10.7 per cent.
Based on the PE ratio’s historical average, the upside potentials derived are 6.5 per cent and 10.8 per cent for the respective periods. Should valuations remain at its current levels, investors may still benefit from attractive dividend yields of 4.8 per cent and 5.3 per cent for FY21 and FY22 respectively.
Takeaway
All in all, the financial sector is currently sailing through uncharted waters. As policymakers move in to cushion the financial impact of the outbreak, banks may continue to face net interest compression.
However, loan moratorium may assist businesses to weather through this challenge while consumers find themselves in a position of financial insecurity. Furthermore, the lower foreign shareholding in the local banking sector also limits further selloff by foreign investors.
For investors that are willing to look past the current thunderstorms, they may consider investing in this sector given the strong capital positions coupled with the cheap valuations.
A notable fund that has a significant weightage in this sector is Eastspring Investment Equity Income Fund which stands at 28.4 per cent as of end-May.