UOB Kay Hian analyst Jonathan Koh has downgraded the Singapore banking sector to “market weight” amid an upcoming interest rate downcycle.
The US Federal Reserve has paused its rate hike for the third straight Federal Open Market Committee (FOMC) meeting on Dec 13 and it is expected to commence rate cuts in 2H2024.
“Based on the dot plot, the median projected path for Fed Funds Rate is 4.6% by end-2024 (previous: 5.1%) and 3.6% by end-2025 (previous: 3.9%), indicating rate cuts of 75 basis points (bps) in 2024 and 100 bps in 2025. The dovish bias can be seen from the downward shift in the dot plot by 50 bps in 2024 and 30 bps in 2025,” writes Koh in his Jan 2 report.
As it is, the FOMC has already begun to deliberate on the appropriate time for rate cuts as Fed officials do not want to cause unintended harm to the economy by keeping interest rates too high for too long when inflation is falling, he adds.
Core inflation in the US seems to have turned the corner already, peaking at 5.6% in February 2022, which was the fastest pace in 30 years. The country’s core inflation eased to 3.2% y-o-y in November 2023, Koh notes.
“Based on economic projections provided by FOMC members as of December 2023, the US economy is expected to expand by 1.4% and core personal consumption expenditures (PCE) inflation to recede to 2.4% in 2024, which reflect continued economic expansion and a likely soft landing,” he says.
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Impact on Singapore banks
The anticipated interest downcycle will have a negative impact on Singapore banks, with the rate cuts likely to result in net interest margin (NIM) compression and lower net interest income (NII) in 2HFY2024 and FY2025.
Valuations for all three banks are currently undemanding with the banks trading at a low P/B of 1.14x, a low P/E of 8.4x and an attractive dividend yield of 6.1% for FY2024.
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Among the banks, Koh likes Oversea-Chinese Banking Corporation (OCBC) the best due to its commitment to maintaining its dividend payout ratio at 50%. The analyst also likes the bank for its consistency in delivering growth in quarterly earnings, focus on trade and investment flows within Asean and defensively low FY2024 P/B of 1.06x.
OCBC also has the highest common equity tier 1 (CET-1) capital adequacy ratio (CAR) of 14.8% and lowest non-performing loan (NPL) ratio of 1.0% as of September 2023.
That said, Koh is also positive on DBS for its excellent execution and consistent good results.
“Management estimated surplus capital at $3 billion or $1.20 per share based on optimal operating range for CET-1 CAR of 12.5% - 13.5%, Koh notes.
He adds: “DBS could consider potential capital management exercise to return surplus capital to shareholders over three years given that Final Basel III Reforms are already finalised and would be implemented starting July 1.”
In FY2024, Koh has forecasted both DBS and OCBC’s NIMs to narrow by 8 bps. DBS’s NIM is expected to narrow by 25 bps in FY2025 while OCBC’s is expected to narrow by 22 bps in the same year.
He also expects DBS’s NII to increase by 1.8% in FY2024 but decline by 8.0% in FY2025. DBS’s earnings are estimated to decline by 5.2% in FY2025. “The interest rate down-cycle reduces FY2025 return on equity (ROE) by 3.7 percentage points to 14.2% compared with its recent peak (FY2023: 17.9%),” he says.
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OCBC’s NII is expected to grow by 0.5% in FY2024 but drop by 5.9% in FY2025. The bank’s earnings is expected to decline by 4.1% in FY2025. “The interest rate down-cycle reduces FY2025 ROE by 1.7 percentage points to 11.7% compared with its recent peak (FY2023: 13.5%),” adds Koh.
Koh has given DBS and OCBC “buy” calls with respective target prices of $41.65 and $16.85.
As at 4.20pm, shares in DBS and OCBC are trading at $33.22 and $12.92 respectively.
