Banking sector defensively placed should SA credit ratings be cut
the build-up to this event.
The question being, how much has already been priced into these assets. Without a doubt, investors have already increased the risk they assign to investing in South Africa and this means that they require higher returns. Within equity markets, one sector that is often credited with having deep roots in an economy is the banking sector – the transmitters of economic participation and activity.
The question remains, what does sub-investment grade mean for South African banks and is it all priced in?
Two major risks that faced the banking sector following the dismissal of Nhlanhla Nene were what would happen with interest rates and inflation.
Currency depreciation was an immediate indicator of a worsened investment climate, which ultimately feeds through into higher inflation.
The Reserve Bank responded by raising interest rates. What we want to avoid is a Brazilian-style emergency rate hikes, an outcome that would not augur well for South African banks.
Almost six months on, interest rates have risen by a relatively modest 75 basis points and the currency is yet to reach the peak levels of R16.86 to the dollar. These outcomes can be attributed to a few positive developments that unfolded at the start of the year, such as greater engagement between business and the government and a tighter fiscal budget which reflected a desire to rein in a growing civil labour force.
This, amid a few other developments, has arguably allowed South Africa’s sovereign rating a stay of execution – after the latest visit by S&P Global Ratings held earlier this month. Banks, however, are not out of the woods, as evidently voted on by market participants and the flat returns on a year-to-date basis.
There are however justifiable concerns in the sector that have centred on the upcoming 12 to 18 months earnings cycle.
From a corporate book perspective, a higher interest rate environment (albeit not aggressive) means higher funding costs, more so for corporate deposits (wholesale funding) rather than for retail deposits. Overlay this with the revenue erosion that has occurred on certain foreign denominated corporate transactions given a weaker currency, where certain projects may have been rendered non-viable.
On fee and commission earnings, slower economic growth and low business confidence have in the past indicated lower transactions occurring in banking, especially from corporates rather than retail.
The net impact of these factors implies a decline in margins. This follows the first half of the 2015 reporting cycle, where banking margins had already come under pressure from the cost of holding increased liquidity, as per the latest capitalisation requirements.
From a retail book perspective, loan growth by the big four banks would be expected to be constrained as the appetite for taking on greater risk wanes when operating in an emerging economy that is expected to deliver sub-par growth.
Having earlier cited greater funding cost pressure for the banks when interest rates are higher; banks have also been known to benefit from a rate hiking cycle.
Simplistically, loans will re-price more than deposits (be it an upward or downward interest rate cycle), therefore margins tend to compress in a downward cycle and open up in an upward cycle.
This is known as the endowment effect and while this should protect margin erosion to a certain degree, a rising interest rate environment tends to bring with it worsening bad debts – especially when faced with a consumer already under significant strain.
Despite all this, it can doomsday is not upon us.
South Africa’s banking sector is perhaps be said that in the best shape it has been in since the fallout of the global financial system in 2008. The sector remains far better capitalised and one could stake greater confidence in the sustainability of each bank’s dividend pay-out profile than most other sectors on the JSE.
The sector dividend yield is at 5.4 percent, close to levels last seen since the 2008 global financial crisis.
Certainly, following the momentous Brexit vote, these yields should seem even more attractive over the short term.
Added to this, the return-on-equity ratios and price-to-book multiples rank relatively well compared with other emerging market peers.
Faced with such valuations, the comment often made is the presumption that the bad news has been priced into current share prices. It would be hard to disagree.
So while we anticipate the eventual downgrade into what this note has successfully managed to avoid referring to – “junk” status – we regard South Africa’s banking sector as relatively defensive, not just as measured against the other domestic sectors, but also against many global peers.
Volatile oil prices and a low-to-negative global interest rate environment are perhaps some of the factors that are likely to provide a floor to what has been a difficult period for share prices locally.
A credit rating downgrade into sub-investment grade is likely by the end of the year and this could potentially result in further asset-price volatility.