Navigating Singapore ~ Banks - Underweight , a story of two halves
Remain Underweight; more downside before upside
- The banks’ share prices have reacted to the higher SIBOR and SOR as the S$ continues on a depreciating path against the US$. Valuations have risen to 0.9- 1.0x CY17F P/BV, up from 0.8-0.9x CY17F P/BV prior to Trump’s victory in the US presidential elections.
- While the market appears to have priced in further NIM upside from a US Fed hike in Dec and expectations of a further 2-3 hikes in 2017, we think it may have lost sight of asset quality pressures that remain in the medium term.
- We think credit migration could be a problem in 1H17 as more firms face cash flow problems and consumers face issues meeting their monthly repayments; these could require higher provisions before the effect of higher rates kick in.
- We estimate that a 50bp rate hike will only be able to offset a 5-7bp rise in credit costs, which is hardly a big number in the face of low- 100% coverage ratios. We think profit growth in 2017 could be challenging as a result.
1H17: Beware of worsening asset quality
- We expect the banks to continue to report high loan loss provisions in their upcoming 4Q16 results, still mostly from oil & gas, as collateral values of offshore support vessels are likely to be written down at year-end. With coverage ratios at 100-111% and the banks’ aim to maintain a minimum 100% ratio, any new NPL recognition could take an immediate hit on the bottomline.
- Furthermore, with Swissco going under judicial management and Rickmers Maritime defaulting on its debt in 4Q16, we think there could be further pressure in the oil & gas industry before the outlook improves. While we acknowledge that most of the chunky vulnerable oil & gas exposures have been recognised as NPLs, the banks’ guidance that the worst of the oil & gas credit cycle is likely over could be premature or overly optimistic, as the pressure on bottomline could still exist as more provisions could be required.
- The banks’ pillar 3 disclosures point to some worrying signs in asset quality. Loans that are past due but have not been recognised as NPLs have risen across the three banks, with the trend especially pronounced at OCBC and UOB. We think part of this could be driven by the oil & gas sector, though there could be some general weakness in other parts of the book as well given the slowdown in the economy. If these past due loans are all taken in as NPLs, coverage ratios could fall to as low as 45% for UOB, 47% for OCBC, and 83% for DBS (latest figures as at 2Q16). This could require a significant top-up in provisions as the banks want to maintain a minimum coverage ratio of 100%.
- Besides the oil & gas sector, we are concerned that asset quality weakness is broadening to other sectors, particularly SMEs. The recent 2016 SME Development Survey by DP Information Group which surveyed 2,513 SMEs revealed that SMEs are finding it increasingly difficult to gain access to financing and cope with the cost of financing. In 2016, 22% of SMEs faced financing issues compared with 14% in 2015. Meanwhile, the percentage of SMEs that face difficulty coping with the cost of financing has increased from 6% in 2015 to 22% in 2016. This was driven by several factors, including:
- higher interest rates charged by banks,
- higher collateral required by banks to maintain the same quantum of loans, and
- tighter access to supplier credit.
- Findings from our channel checks on the ground also confirm the same trend, i.e. that banks are limiting their exposure to SMEs, with more stringent credit policies in extending loans to SMEs. In a protracted downturn, SMEs are the most susceptible to asset quality challenges as they could face cash flow issues with little access to financing. We believe UOB has the largest exposure to SMEs at 20% of loans.
- We would also look out for any spike in the unemployment rate as an indicator of worsening asset quality. The unemployment rate has inched up to 2.1% recently, with potentially more job cuts in 2017 across all sectors to reduce costs amid a slow revenue growth environment. Recent job cuts have mainly affected contract staff and foreign workers, but residents could be affected next year. This could have negative implications on the mortgage book, as the lack of income could affect the borrowers' ability to meet monthly payments.
2H17: Some breathing room from rising rates
- We see a better outlook for Singapore's banks in 2H17 as we expect the extent of the asset quality challenges to be better known, while the impact of higher rates should flow through to NIMs as floating rate loans typically take 3-6 months to reprice.
- DBS previously guided that with flat margins, it could achieve 4% net interest income (NII) growth in 2017, while a 50bp rate hike could lead to 6-7% NII growth. Taking this as a guide, we estimate that the higher NII can offset credit costs by 5-7bp, especially towards 2H17 when the full loan repricing effect has flowed through to NII while asset quality challenges would be mostly over.
- However, there are some caveats. Looking at the recent movements in interest rates, the 3M SIBOR and SOR appear to have moved ahead of the US Fed Funds Rate and the 3M US$ LIBOR. Thus, the S$ market appears to be pricing in expectation of steeper or more rate hikes than the US$ market. Our regression analysis of data from 2000-2016 suggests that for every 100bp increase in the US Fed Funds Rate, there will be an equal movement in the 3M US$ LIBOR, while the 3M SOR and 3M SIBOR will rise by 47bp and 43bp, respectively. Based on this historical relationship, current rates suggest that the S$ market has already priced in 1-2 Fed hikes of 25bp each. This leaves little room for upside to the 3M SOR and SIBOR when the US Fed actually hikes rates, likely once in Dec and twice in 2017.
- We also note that the SIBOR and SOR have a close relationship to the US$/S$, given Monetary Authority of Singapore's (MAS) policy of pegging the exchange rate to a basket of currencies rather than directly controlling interest rates. Thus, the SIBOR/SOR could be susceptible to currency movements should the MAS intervene to ensure the S$ does not continue on a sharp depreciating path against the US$, given its current zero appreciation stance for the Singapore dollar nominal effective exchange rate (S$NEER).
- Our Underweight call is mainly premised on expectations of weak 4Q16 results and asset quality concerns in the medium term, particularly in the SME segment which forms up to 20% of loans (UOB).
- The key upside risks to our call include stronger domestic GDP growth in 2017 beyond MAS’s 1-2% forecast, lower unemployment rate, improved access to financing for SMEs, new government grants and measures to lift economic growth, stronger intraregional trade flows and investments, and if Trump’s policies do not have a disruptive effect on emerging Asian economies.