The Australian financial sector is in good heart with solid earnings, stronger balance sheets and growing dividends. But it will not be all plain sailing. Business editor Dene Mackenzie reviews the latest Morningstar outlook.
Australia's major banks are well placed to cope with slower economic conditions, Morningstar financials sector head David Ellis says.
All four major banks, National Australia Bank, the Commonwealth Bank of Australia, Westpac and ANZ, were undervalued compared to Morningstar's fair value estimates.
NAB, which owns the BNZ in New Zealand, and CBA, which owns ASB, in New Zealand, were Morningstar's preferred exposures.
''Despite an outlook for Australia's growth to moderate, we remain confident in the long-term outlook for the major banks - reflecting a modest improvement in demand for credit, improved productivity and benign bad debts.''
Market momentum supported that view, with credit growing by about 6%, customer deposits growing by 10% and asset quality continuing to improve, he said.
Major banks were benefiting from strong competitive advantages, large scale, strong brands, high customer switching costs and increasing focus on product innovation and customer service.
Key risks for the banking sector were higher-than-expected loan losses and tougher regulatory capital requirements, Mr Ellis said.
Early-stage loan losses were starting to appear in the resources and agriculture sectors of the Australian and New Zealand economies.
Despite risks around loan losses and tighter regulations, the major banks' competitive advantages protected excess shareholder returns for a prolonged period.
Growth in average earnings per share for the major banks was forecast to be near 5% for the 2016 and 2017 financial years.
Dividend payouts within the 70% to 75% range, cost-to-income ratios between 41% and 45% and softer returns on equity would also feature, he said.
''Demand for mortgage credit will increase broadly in line with current owner-occupier levels of 5%-6% as the lending to property investors slows from current levels of more than 10% to somewhat less than 10%.''
Long-term demand for mortgages was closely linked to the pace of employment growth, wages growth, interest rates, population growth, household formation and housing affordability, Mr Ellis said.
More importantly, markets were waiting for the long-awaited recovery in business lending for the medium-term. Loan growth assumptions had eased from an average 6% a year to about 5.5%.
Average loan rates were forecast to rise to 0.25% in the next five years, compared with 0.19% in the past three years. Loan losses remained low but in third-quarter 2015, ANZ reported higher losses than expected.
Pressure was coming from the mining and agricultural sectors.
Insurance
General insurers were well placed to generate solid earnings growth but lower premiums and higher claims costs were making it more difficult for the sector to outperform, Mr Ellis said.
Competition was weighing on premiums and was likely to continue, but there were signs of premium stabilisation.
Premiums were expected to increase modestly in the next several years.
Despite the challenges, extensive work undertaken by management to improve efficiency and strengthen businesses was delivering. Cost ratios were declining, surplus capital was building and provisions were increasing, providing scope for good earnings growth in the future, he said.
To offset pressure on premium growth, insurers continued to focus on tightening underwriting standards, taking costs out and improving efficiency.
Morningstar made no change to its positive long-term view on the listed health insurers.
The healthcare sector would increasingly benefit from the same demographic help to those of the wealth management industry.
Wealth management
Equity managers had experienced increased pressure during the past six months but, in the long term, Australian wealth managers were well positioned to benefit from positive trends in investment markets and slowly improving investment flows, Mr Ellis said.
While earnings were volatile, given exposure to investment markets and high operating leverage, long-term industry fundamentals remained attractive.
Risks stemmed from the potential for adverse regulatory outcomes in the areas of financial advice, superannuation and tax, the rise of lower-cost investment alternatives such as exchanged-traded funds and emerging new technology such as robo-advice, he said.
Property sector
In the face of a meaningful sell-off in the broader equities market, the Australian listed property sector had materially outperformed the broader market - up 4.3% in the nine months to the end of September compared with a 7.2% fall in the S&P ASX200.
The resilience of the property market was primarily explained by two factors: defensive medium-term earnings and underpinned by long leases and the annual rental increases linked to inflation or a fixed rate; persistently low interest rates driving ongoing demand for yield stocks.
However, most property stocks had eased lower and there were some good options available for income investors, Mr Ellis said.
''We expect central banks to keep official interest rates low for some years as many components of the global economy remain weak. There is a disincentive to raise interest rates, as countries moving first will see their currencies strengthen, eroding their global competitiveness.''
Interest rates on longer-dated debt were more difficult to control and could rise, despite efforts by central banks, he said.
The softening Australian economic outlook was likely to diminish demand for office space and dampen retail sales, affecting rents.
Further, supply was increasing in many markets as significant capital was being deployed to build new property assets - attracted by high yields compared with very depressed long-term borrowing costs.
Morningstar had concerns about Australian residential development as speculation appeared to have driven the rate of supply above underlying demand.
Prices were expected to soften to absorb excess supply, Mr Ellis said.
Morningstar had a ''cautious outlook'' for the Australian office sector, given Brisbane, Perth and Canberra were all oversupplied.
Sydney was expected to be oversupplied from 2016.
Rents were likely to fall on most expiring leases and vacancies could trend higher, a major barrier for growth in rental income.
