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SA BANKS: CHOPPY WATERS,
BUT STILL ON COURSE
Sep 26, 2023
At Sanlam Private Wealth, we’ve been positive on the South African banking sector over the past few years. We’ve been of the view that bank earnings would prove to be resilient and rebound, setting the scene for local banks to generate significant returns from the low valuations in 2020 as these shares were indiscriminately sold by investors.
First we had the pandemic, followed by the war in Ukraine, rising inflation, the US regional banking crisis and persistent loadshedding. None of these have succeeded in derailing South African banks, which have continued to exceed expectations. In the face of extreme macroeconomic volatility, they have delivered earnings growth, bought back shares, paid dividends, and seen returns on equity expand towards their medium-term targets and exceed the cost of capital, while maintaining excess capital.
Our analysis during the initial stages of Covid-19 underpinned our conviction about the sector, and we bought banking shares when valuations had fallen significantly amid the macroeconomic uncertainty. We believed our banks were conservatively managed and, through scenario testing around bad debts, we had conviction in our call to buy these resilient businesses, believing that over time they would recover and generate good returns.
In our estimation of the four major banks – Absa, First National, Nedbank and Standard Bank – as well as Capitec and Investec, revenue will exceed 2019 levels by R139 billion in 2023, representing growth of 37%. The growth has been driven by a sharp increase in net interest margins as interest rates rose from 2020 lows, propelling earnings and valuations higher.
Profitability is at the upper end of the 10-year range, with Absa, Standard Bank and Investec exceeding their 2019 pre-pandemic levels and all banks showing vastly improved profitability levels over the past three years, along with expectations for return on equity to remain high over the next two years.
In the aftermath of the pandemic and subsequent recovery phase, how do we evaluate the sustainability of growth in the banking sector – especially since banks are no longer trading at fire-sale valuations and expectations are running high?
We’re no longer in an environment of decades-low interest rates, with the South African prime rate at 11.75% (currently higher than pre-Covid-19 levels), increasing by 4.75% over the past two years as the South African Reserve Bank (SARB) raised rates to combat inflation and contend with rising global interest rates.
Will a continuing high interest rate environment benefit our banks? There appears to be a trade-off at play. We’ve seen a 1% increase in interest rates generating earnings increases for the banks of between 3% and 6%, with Standard Bank and Nedbank benefiting the most since they’ve been more sensitive to interest rate changes than the other banks. The extent of rate hikes over a very short period of time has therefore been positive for the banks – but this scenario is unlikely to be repeated.
The flip side of this equation is that the sharp interest rate rises have put pressure on consumers, evidenced by the increase in bank impairments in their latest results. The banks have reported signs of strain in parts of their retail lending portfolios as customers struggle with home loans and vehicle repayments in the face of increased borrowing costs. In addition, South Africans are having to contend with rising fuel and food costs. If the current environment persists, these consumer constraints will translate into impairment pressure for banks.
While more rate hikes are likely to curtail profitability and keep impairments at higher-than-anticipated levels, it’s worth noting that bank provisioning is at historic highs and private sector credit has not grown significantly in recent years – and not for a lack of demand for credit.
Banks have been focusing on asset quality when growing their loan books and, considering the deteriorating economic environment, are becoming more cautious in granting new loans. The high levels of provisioning and conservative lending practices provide some comfort that they’ll be able to navigate future pressures. We don’t expect bad debts to exceed previous crisis levels.
With high interest rates and a slowing economy, why do we remain constructive on the banking sector? The uncertain macroeconomic outlook will affect banks in two ways. First, with local inflation back within the SARB’s target range of 3% to 6%, we believe further rate hikes will be muted. This is good news for both consumers and banks, which are likely to see a decrease in bad debts going forward.
Second, since their fortunes are inextricably linked to those of the economy in general, banks can expect a slowdown in growth over the long term. South Africa’s economic woes are well known, with loadshedding, failing infrastructure, government inertia and high unemployment among the issues our country is grappling with.
We therefore prefer Standard Bank and Absa from an investment perspective, since these two banks have increasing exposure to Africa. Their African operations are growing faster than their local loan books. We like the fact that these businesses have access to faster-growing markets outside South Africa. While these markets do have their own idiosyncratic risks, they offer higher growth potential and returns.
South Africa’s economic woes do, however, present opportunities for growth for local banks, especially the ‘big four’. Loadshedding has resulted in renewable energy projects at all levels of the economy requiring finance – from government infrastructure projects to large corporates securing their future energy needs and small businesses and individuals seeking solutions to keep the lights on. These financing deals could be lucrative for the banks at multiple levels, as well as aid in solving our country’s energy crisis.
From an investment point of view, we at Sanlam Private Wealth continue to believe that in the absence of robust local economic growth over the medium term, our selection of banks will provide good returns for our clients. They will generate positive earnings growth over time, and they’re well positioned to continue paying dividends.
For this reason, we recently added to Absa and we maintain our preference for Standard Bank. In our view, these continue to be good businesses. We do, however, remain cognisant of the risks within the sector, and we continue to monitor our overall position size in our clients’ portfolios.
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