Tougher ride ahead for S-E Asia's banks

MORGAN Stanley's Asian economics team, led by my colleague Deyi Tan, remains concerned about the impact of trade tensions on GDP growth in the region. In particular the team worries that continued uncertainty will affect investment activity and that downside risks to forecasts are increasing. In early July, it lowered its 2019 Asia (ex-Japan) GDP forecast further to 5.6 per cent, a slowdown from 6.2 per cent in 2018. If this forecast is achieved, it will be the lowest annual growth rate since the Global Financial Crisis.

We expect Asean countries to be affected because they are trading partners with the US, Europe and China. Singapore's economy is most exposed given its high level of financial and trade linkages. We expect that Singapore GDP growth will slow to 1.5 per cent in 2019 (from 3.1 per cent in 2018). Malaysia and Thailand will also experience some pressures in our view (we see Thailand GDP growth falling to 2.8 per cent in 2019e), whilst the more domestically focused Indonesia and the Philippines would be less exposed, with GDP growth remaining in the 5-6 per cent range for both.

As someone who looks at the region's banks, I am interested in how this growth slowdown will affect bank earnings and share prices. Typically, a softer economy will drive a slowdown in loan growth, softer fees and an increase in credit risks. In addition, a growth slowdown can be accompanied by lower interest rates (we expect the US Federal Reserve to cut rates this week) and in most cases, as rates fall so does the interest income that banks earn. Given that many banks in South-East Asia cannot offset all of this through lower deposit rates, their net interest margin (commonly known as NIM) falls.

I see the largest earnings risk over the next 12 months at Singapore banks. A softer economy is already resulting in relatively slow loan growth and whilst fees are still recovering from low levels due to weak market activity at the end of 2H18 we see this rebound slowing as the economic outlook deteriorates. Credit quality will probably be fine in this cycle, but the risk is to the downside. The biggest problem the Singapore banks face, however, is on net interest income. All the local banks have seen earnings and share price benefits as global and Singapore interest rates picked up from their lows at the end of 2017. With these rates now expected to peak, at least some of these benefits will reverse and we believe it will be difficult for the Singapore banks to outperform in a falling interest rate environment.

Having said that, we expect that Singapore banks will do better over the next 12 months than they did in the last rate cutting cycle. From 2007-2017 they faced the challenge of falling NIM and, at the same time, had to increase the capital that they held. This led to a fall in returns, and the stocks de-rated. Today the banks have strong capital levels. We believe that they will be able to maintain dividend payouts, even if they face some earnings headwinds, and this should provide share price support.

In contrast to Singapore, I think Indonesian banks should benefit from the economic environment over the next 12 months. The Indonesian central bank, Bank Indonesia, cut interest rates by 25bps two weeks ago. Our economics team believes that this is the first of four cuts in the next few months. In total we expect interest rates in Indonesia to fall by another 75bps by the end of this year.

We see these falling rates delivering a number of benefits to Indonesian banks. Firstly, we expect that lower rates will help support business loan growth, which has already been recovering over the last 12 months, and in addition could stimulate consumer loan growth. If the latter happens, then Indonesian lending growth could accelerate from its current level of 11 per cent YoY to closer to 13 per cent (the more domestic orientated Indonesian economy is less vulnerable to outside growth pressures than Singapore).

In addition, Indonesian banks' NIM benefits from falling rates. This is because of a slightly unusual structure whereby loans reprice much more slowly than deposits. Thus as rates fall, Indonesian banks see their deposit costs fall quite quickly, but it can take up to a year for loan rates to follow. It is true that Indonesian banks trade at higher price to earnings and price to book multiples than other South East Asian banks, but longer term structural growth prospects are also better, which we believe more than justifies these multiples.

Elsewhere in Asean, slowing trade and lower rates will have less of an impact. Even so, we see pressure on loan growth and fees in Thailand and Malaysia, and pressure on net interest margins for Philippine banks as interest rates fall. We therefore recommend investors to continue to favour more defensive banks in these markets.