Weekly Broker Wrap: Australian banks; wage inflation; and copper.
-Subdued earnings outlook for banks now well incorporated into share prices
-If Royal Commission leads to class actions then risks are skewed to the downside for banks
-Credit Suisse: underlying trends in wage inflation likely to remain soft for some time
-China's changes to scrap imports could potentially tighten trade and drive prices higher
First half results from both Commonwealth Bank ((CBA)) and Bendigo and Adelaide ((BEN)) as well as National Australia Bank's ((NAB)) first quarter update signal robust underlying trends, and UBS also notes asset quality is sound. Yet the share prices have struggled, materially underperforming both global banks and the domestic market.
The broker believes the earnings outlook, subdued it may be, is now well understood and largely incorporated into prices. The focus is on the Royal Commission, and if this finds the banks have not been responsible lenders it could potentially open up class actions, which may have material consequences.
Nevertheless, following 73 investigations into the banks since the global financial crisis UBS understands investors are complacent about these risks. Hence, if investors believe the Royal Commission will have more bark than bite the banks appear fairly priced.
However, if the housing market slows faster than anticipated or the Royal Commission leads to class actions for mis-selling then risks are skewed to the downside.
The updates were largely consistent with Macquarie's expectations. Favourable margin trends was supported by re-pricing benefits and improved funding conditions. This was partly offset by the bank levy. Credit conditions remain benign, the broker observes.
Macquarie suggests, at current multiples, the sector is not priced for an upgrade cycle. The broker agrees asset quality is sound and notes the share of interest-only lending has declined materially since the introduction of a 30% cap. All the banks are considered, currently, safely under this cap.
APRA released its discussion paper during the reporting season and while at this point Macquarie is not able to make conclusive estimates, material capital implications are not envisaged for the major banks. From a valuation standpoint Macquarie suggests the sector is attractive.
Credit Suisse has developed a model to track wage inflation based on enterprise bargaining agreements, the National Australia Bank business survey and a proprietary measure of labour market slack.
The model points to an underlying trend in wage inflation of around 1.6-1.8% annualised to the June quarter of 2018. Such indicators are telling the broker that the underlying trend in wage inflation remains quite soft.
Reserve Bank officials have repeatedly expressed a view that accelerating wage inflation is a trigger for rate hikes as the labour market tightens. The RBA's stated view is that wage inflation will pick up gradually over the next few years.
However, the broker notes, in the February's RBA Statement officials included some rather dovish commentary and downplayed the risk of the near-term upward inflection point for wage inflation.
Credit Suisse interprets this as, while retaining a high conviction that wage inflation will gradually pick up, officials are creating room in the narrative for a more disappointing data in the short term.
On the broker's modelling, wage inflation could actually slow further. Not only would this have implications for the timing of official rate adjustments but also negative implications for consumption.
Citi observes the latest speech from RBA Assistant Governor (Financial System), Michele Bullock, on household and mortgage stress, concluded that the overall level of stress among mortgaged households remains relatively low. Therefore the risks to financial stability from this source are also low, although developments should be watched carefully.
The most interesting comment for investors, the broker suggests, is that the more debt households maintain, the more sensitive cash flow and consumption will be to a rise in interest rates.
As a result, Citi believes the RBA will raise rates very cautiously and slowly and only when wages and inflation are rising substantially. The broker envisages the start of the rate hike cycle is an end-of-year proposition at best and more likely in the first half of 2019.
China is implementing changes to copper scrap import rules. This has potential, UBS suggests, to materially tighten the copper trade and drive prices higher. Changes are due to be implemented on March 1, 2018. The broker estimates the impact could be around 2% of global refined copper demand.
This could be higher if customs officials interpret the policy strictly. This "National Sword" policy restricts imports of scrap to end users and introduces quality limits of 1% impurities as well as reduces trade quotas. The policy is designed to reduce pollution from the scrap industry, particularly from processing lower-grade scrap.
UBS suggests there may be a shift in lower-grade scrap processing to other emerging Asian economies but this would take time. Mine supply may also be more reliable this year, after a very disrupted 2017.
Were disruptions to be normalised this would add around 300,000 tpa of mine supply that was lost in 2017. UBS suggests a deficit is likely to be maintained in 2018, as while China's demand is set to moderate the rest of the world is accelerating.
UBS points out scrap use in 2017 was around 8mt of global copper consumption, which was around 29mt. Scrap is one of the least transparent portions of the copper supply chain as there are a number of suppliers and lack of good cost information. Scrap supply is also pro-cyclical so that when global industrial production is elevated so to is the generation of scrap.
The broker asserts that the marginal cost of scrap is more relevant to copper prices than mine supply. UBS forecasts copper prices of US$3.00/lb for 2018 and 2019, roughly in line with spot prices and notes the spot market is not pricing in significant scrap supply disruption.
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