The first signs came when Nedbank issued a trading update in late May. Earnings for the half-year to fall by at least 20%, bad debts to rise. This was not unexpected but was still a cold reminder that South African banks, much like banks overseas, are entering a tough period.
Warnings from all the other banks soon followed. All the conditions are against the banks: A flat economy, many clients in financial distress, and interest rate cuts adding up to 275 basis points (bps) so far this year. How bad is it going to get?
“We issued our trading update at our AGM, which happens to be the first of the bank AGM season,” says Mike Brown, CE of Nedbank. “All the other banks have issued similar warnings. It’s a JSE requirement once a company is reasonably certain headline earnings will be more than 20% down on the prior period.”
How bad is it going to get? “The economic fall-out of the Covid-19 lockdown will have a significant impact on the banks’ non-performing loans and credit losses,” says Jonathan Wernick and Alec Abraham, equity analysts at Sasfin Securities. “And the low confidence and negative endowment effect of low interest rates will drag on earnings, not only in 2020 but extending into 2021. While the Bank Index has recovered from its lows in March, it is still some 36% down for the year to date.”
But the situation for banks is not as dire as it could be. Kokkie Kooyman, a portfolio manager and director at Denker Capital, sees opportunities in the gloom. “Based on our research and interactions with management, we believe very few banks will generate losses in in 2020 or 2021 and that they’ll continue to grow shareholder value. In terms of valuations, the financial sector is currently at a larger discount to the MSCI World Index than ever before – indicating it is at the epicentre of fear.
“The fears of seemingly unquantifiable risks have pushed share prices down to levels that create excellent investment opportunities.”
Looking at Nedbank Brown says it’s very difficult to forecast accurately in the current environment. “While we know this year’s earnings will be down on last year, I’m sure that over time bank earnings will recover to pre-Covid levels. What is uncertain is how fast the economy will recover and as a result how fast this recovery in bank earnings will take place.”
Looking at the reasons for banks’ underperformance, banking analyst Simon Stockley, who also heads his own company Catalis, a boutique investment and advisory service, says a combination of factors has created a “perfect storm” for banks.
“Banks are making less revenue from interest charges. Lack of deal flow is likely to affect earnings in the short term and increasing levels of unemployment will make it difficult for average South Africans to service their debt obligations,” Stockley says.
Perhaps the biggest problem for banks is low interest rates, at a low not seen in South Africa for many years. That’s squeezing banks’ net interest income and income margins, which in turn knocks down earnings.
Are more interest rate cuts to come, which will further choke banks’ earnings?
Kooyman says he has no clue what the SA Reserve Bank might do next. “They can’t cut much more. If SARB cuts more they risk further currency weakness. It partly depends on the appetite for emerging markets (EM). If US growth strengthens then capital will flow back to EM for a while. And then the SARB could risk another rate cut.”
Kooyman says globally banks have adapted to lower interest rates by increasingly digitizing and cutting costs. “That is, cutting costs at braches and by less people. In South Africa the unions won’t like that so the process will be slower.”
“Our current forecast is for rates to remain flat from here, with the possibility of one more 25 bps cut this cycle,” says Nedbank’s Brown.
But eventually, earnings growth will start to recover. It might take a long time. How long, for earnings to get back to pre-Covid-19 levels?
“It’s likely to take some time. I would say at least three years. Yet I expect all the banks to bounce back – eventually,” says Stockley.
Kooyman says each country differs according to the depth of the recession, the paid taken and the strength of the recovery. “The US is one of the best cases. We see banks there back to 2019 profit levels by the end of 2022, maybe 2023. In South Africa, I think profit levels will be back by 2023, the latest 2025.”
Brown says in the global financial crises, South African banks’ earnings peaked in 2008 before dropping in 2009. “And three years later, in 2011, they again exceeded the 2008 peak. Much will depend on South Africa’s policy response to the crises.”
With banks under pressure, bank shares have also declined. So what should potential investors do, is now a good time to buy bank shares?
“If you are a potential investor in the sector adopt a wait and see attitude and see how the situation and pandemic develops,” says Stockley. “I suspect prices will still fall before they start to come back. If you are invested in the sector, stay invested. And if you’re thinking of opening a bank anytime soon, don’t.”
Kooyman says bank shares in South Africa are attractively priced. “Like banks all around the world, the quality of lending portfolios is high. Most important to bear in mind in 2020 is that: unlike previous crises, this one doesn’t follow a lending bubble; and banks’ balance sheets have been cleaned up and they hold double the capital they did in 2008.”
Abraham and Wernick from Sasfin Securities don’t believe the current prices of banking shares fully reflect the Covid-19 fallout and the weak medium term South African economic outlook. And as they have said, the Bank Index is still about 36% down over the year.
One point all the commentators agree on is that now is not a good time to start a bank. But while your bank gets poorer, though it will eventually recover, why not get richer buying bank shares.