SA banks have been operating well despite the uncertain macroeconomic environment, shifting political landscape and the highest interest rates in more than a decade. Despite these challenges the sector has remained remarkably resilient, continuing to grow profitability and mostly improve returns.
As interest rates start to fall, the endowment benefit will wane but the elevated levels of credit losses and improved activity levels should provide a comfortable level of support to earnings growth.
Navigating the worst in the credit cycle
The banks have managed to get through some of the highest interest rates in more than 10 years. This was particularly challenging in retail lending, in which most SA loans are on variable rates. As interest rates increase so do monthly repayments, placing citizens under financial strain. But as interest rates reduce it will reverse.
The rate reduction will not only allow overindebted consumers to play catch up, it will allow new customers the opportunity to access loans at more affordable instalments. While there may be a lag between a rate reduction and the pickup in new business demand, it is usually temporary and the outlook for asset growth remains positive.
The cost of risk is now at or above long-term, through-the-cycle ranges. The continued decline in impairments will be a meaningful driver of earnings growth in the sector. As interest rates have started to come off their highs, nonperforming loans are also improving, though this recovery is generally slow as consumers take time to recover. However, rates have notably passed the peak point. Recent pre-close guidance issued by the banks indicate that the credit loss experience is better than previously expected. While it is still early, the two-pot pension withdrawals could be partly funding debt paydowns.
Asset growth potential with the GNU
As positivity improves about the SA Inc narrative, this could be good for the macroeconomic outlook, which in turn will be supportive of asset growth in the banking sector. While the consensus is, in our view, pricing in a normal recovery, it is not accounting for any benefit from the government attracting additional investment.
The typical lead time on new corporate investments is 12-18 months. We remain optimistic that this benefit could be more material than what is now anticipated by the market and will start becoming more evident into 2025.
Among SA banks Absa stands out as a top pick. We share why we prefer Absa, and outline what we like about the investment case.
Absa is a universal bank with a diversified, pan-African franchise that should over time deliver a return on equity (ROE) in excess of 18%. While the present ROE is some way off at about 14%, recent management changes have been encouraging. The market has responded positively, and since the change in leadership Absa has outperformed its peers. The graph shows the significant positive price action on Absa after the management changes of August 19 last year.
As interest rates decline the endowment impact (the interest income the banks earn on accumulated capital) will come under pressure as returns are reduced. Absa has hedged against the impact of interest rate fluctuations, a strategy it adopted under Barclays’ ownership. This protects the bank from fluctuations in interest income due to changing rates, offering margin stability.
Part of the market’s deep frustration with Absa has been the series of one-off challenges, such as losses in Nigeria, as well as the hyperinflationary accounting and sovereign debt write-downs in Ghana. While the hyperinflationary accounting issue will persist into the first half of the year, the rest are largely in the base. With improved focus on country risk and treasury management Absa is unlikely to face these issues in future. These factors alone could drive substantial earnings growth over the next two years.
Absa’s impairment levels are elevated compared with peers, as well as its own history, due to the balance sheet led strategy, as seen in the second graph. With a credit loss ratio of about 1.2% it remains the highest of the big four banks. However, as interest rates decline credit losses are expected to normalise, which will benefit Absa more relative to its peer group.
Absa has historically focused on market share and revenue growth ahead of return considerations. The market was always critical of Absa’s capital allocation. Under the new management team all these issues are being reviewed, with a laser focus on returns and profitability. The embedded self-help and a renewed focus on noninterest revenue generation (which is ROE enhancing) will help to improve the return back up to about 18%.
Banks — a safe bet for investors
The SA banking sector remains a safe investment choice, supported by positive sentiment that could further improve returns and the potential benefits of lower bond yields that have a positive effect on cost of equity. As interest rates decrease we believe the banking sector will deliver better-than-expected returns.
• Swanepoel is equity analyst at M&G Investments.
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