Buying opportunity? SA banks well capitalised, despite downgrades – analyst

By Liesl Peyper

Cape Town – Most of the local and foreign investors seem to have lowered their expectations for a sovereign credit ratings downgrade as is evident in the rand strength and South Africa’s 10-year bond yields close to 8.2%, said Nkareng Mpobane, fund manager at Ashburton Investments in a company note.

Foreign investors have been buying South African banking stocks on the back of the cheapest valuations relative to emerging-market peers since 2011, despite South Africa’s sovereign credit rating being downgraded to junk by S&P Global Ratings and Fitch following President Jacob Zuma’s Cabinet reshuffle on March 31, which saw the removal of finance minister Pravin Gordhan and his deputy, Mcebisi Jonas.

Mixed denomination rand currency banknotes are arranged for a photograph at a First National Bank (FNB) branch in Johannesburg, South Africa, on Friday, March 15, 2013. Photographer: Nadine Hutton/Bloomberg

“Moody’s however has not yet downgraded South Africa and has placed the country on a 90-day review. The ratings agency has South Africa ranked two notches above junk status at Baa2, with a negative outlook.

In the wake of the Cabinet reshuffle and the subsequent downgrades by S&P and Fitch, the rand initially lost close to 10% of its value touching the R14/$ level. It has since recovered significantly in the aftermath of the recent turbulence and traded at R13.00/$ at 06:30 on Tuesday.

In the immediate aftermath of the Cabinet reshuffle and ratings downgrade, the six-member bank index declined by over 10%, resulting in a loss of R61bn.

Mpobane, noted that there are short-term, medium-term and long-term risks in the banking sector that investors need to be cognisant of though.

Short-term risks

There could be a readjustment of share prices of banks in the short term. “Higher bond yields mean that when one is calculating the shares a higher discount factor would be used, resulting in a lower valuation.”

Both FirstRand and Standard Bank, he said, are trading at multiples below their three year mean. Prior to the latest pressures, Mpobane said, these shares were deemed to be fairly valued. “Recent price weakness however suggest that they are now attractively priced.”

Ashburton doesn’t foresee that any of the banks would need to cut dividends on a two-year outlook, except Barclays Group Africa where its management has indicated there would be a higher dividend cover ratio.

The recent price pressure means that dividend yields in the banking sector now range between 5.5% to 7.5%.

Medium-term risks

On the medium term, the banking sector’s profitability may be affected. “With the latest downgrades we are likely to factor in continued deterioration of the rand, higher inflation and flat interest rates with risks to the upside,” Mpobane said.

In such an environment Ashburton expects diminished economic growth as business confidence wanes, which in turn poses employment risks.

As far as banks are concerned, Mpobane said he would closely monitor the top-line growth drivers of net interest income and non-interest revenues.

“Impairments would also likely worsen as South Africa moves deeper into sub-investment grade, depending on the inflation rate and the South African Reserve Bank’s response to that.”

Ashburton however expects the banking sector to remain “relatively resilient” from an earnings perspective in the 2017 financial year as higher banking fees would be passed on to consumers.

Long-term risks

Mpobane noted that South Africa’s banks are well capitalised.

The sector averages approximately 13% on the Common Equity Tier 1 (CET1) scorecard, while the minimum regulatory requirement is 10.375% for a particular financial year.

(The Tier 1 common capital ratio shows how well a bank can withstand financial stress and remain solvent.)

Mpobane said the banking sector’s risk-weighted assets will be re-priced following the recent downgrades of South Africa’s banks (on the back of the sovereign credit ratings downgrade).

Although banks’ funding is an important aspect of the longer term assessments of the sector, banks have consistently been building up sources of stable funding and liquidity with minimal adverse impacts to their margins.

“We would expect the sector would be able to pass on the higher costs of funding to the consumer, within reason,” Mpobane said. – Fin24

Source: http://www.fin24.com/Companies/Financial-Services/banking-sector-still-well-capitalised-despite-downgrades-analyst-20170424

From Ashburton Investments:

A view of SA banks

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.

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.

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