3 reasons why we believe Singapore banks still have ample room for growth

We expect the Fed will follow through with additional rate hikes in 2019, albeit at a slower pace, and that could drive further expansion in the NIMs of Singapore banks.

While overall loan growth has been slowing, certain sectors remain bright spots that could help pick up the slack, and we expect loan growth in 2019 to still come in at a moderate 5% - 6%.

With the emergence of a wealthy middle-class in Asia, wealth management will be a strong growth engine for the Singapore banks in the long-run.

Based on our analysis, we believe the 3 local banks are attractively valued, with their high dividend yields also providing support to their share prices.

Singapore banks started 2018 on a positive note, with their share price performance supported by rising interest rates and a property market upcycle. However, markets went south in 2H18 as trade war concerns and expectations of a global growth slowdown weighed on market sentiment (Chart 1). The introduction of new property cooling measures further contributed to the sell-off in banking shares.

Chart 1: Price movements of Singapore banks

While global uncertainty remains, we believe Singapore banks can still thrive in this rising-rate environment. With downside risks also largely priced in, current valuations present investors with an attractive entry point into Singapore's banking sector.

NIM expansion to drive earnings

The net interest margin (NIM) of a bank is a measure of the difference between its interest income and interest expense, relative to the bank's total interest-earning assets. Singapore banks often use the 3-month SIBOR to price their loans, and this benchmark rate has historically tracked the movements in the US Federal funds rate closely (Chart 2).

Chart 2: 3-month SIBOR generally tracks US Federal fund rates

We believe that moving forward into 2019, the Fed will likely follow through with additional rate hikes, albeit at a slower pace. Coupled with the lagged impact of recent loan repricing, we expect to see higher loan yields and hence higher interest income. On the other hand, interest rates on deposits have been rising at a slower pace as a significant portion of the banks' deposits comes from current accounts and savings accounts (CASA), whose yields are generally low and stable.

Chart 3: Strong correlation between interest rates spread and NIMs

This has led to a widening interest rate spread and given that the banks' NIM tracks the interest rate environment closely, we see more room for further NIM expansion in the next few quarters (Chart 3). A widening NIM is positive for banks as it means interest income is increasing faster than interest expense, leading to an overall increase in profitability. The continued NIM expansion will also serve as a share price catalyst for Singapore banks in 2019.

Wealth management as a future growth driver

Chart 4: Increasing proportion of total fees from wealth management business

Besides net interest income, Singapore banks have shown strong growth in their non-interest income, particularly wealth management fees. In the past decade, wealth management fees across all three banks have grown significantly from a mere 5% to a third of total fees and commission income today (Chart 4). In wealth management, total assets under management (AUM) can be said to be the single most important element as banks earn recurring revenue based on the amount of AUM they have.

Chart 5: Projected asset and wealth management AUM in Asia Pacific

According to PwC's analysis (Chart 5), the asset and wealth management AUM in the Asia Pacific is projected to grow from USD 15.1 trillion in 2017 to USD 29.6 trillion by 2025 – that's a compounded annual growth rate (CAGR) of about 8.9%. Moreover, as a financial centre and a modern business hub, Singapore serves as a gateway to Asia for many asset management firms and investors to tap on Asia's growth potential. This put Singapore banks in a very good position to capitalize on these opportunities to grow their AUM.

Over the past few years, Singapore banks have been consolidating their market share in wealth management, which directly boosted their total AUM. This allowed them to benefit through higher recurring revenue and further exposure to other key markets in the Asia region. For instance, the acquisition of ANZ wealth management added a large customer base to DBS (SGX.D05) in Indonesia and Taiwan, where they lack presence prior to the acquisition. The acquisition of Barclays wealth management by OCBC (SGX.O39) also helped to deepen OCBC's presence in two of its core markets – Greater China and Singapore.

Coupled with the gradual opening up of China's financial market, we believe that Singapore banks will be able to further expand their footprints in the wealth management industry. In fact, DBS has gone beyond Asia and has begun their Middle East expansion to target the region's wealthy while OCBC has unveiled plans to launch its wealth management business in the Greater Bay Area. The withdrawal of several smaller Western players from the Asian markets makes it even more favourable for the Singapore banks to increase their market share in this business.

Hence, with management commitment to building up their AUM, coupled with the emergence of a wealthy middle-class and ongoing urbanisation in Asia, we believe wealth management will be a future growth driver for the banks.

Positive loan growth from bright spots in the economy

In 2019, overall loan growth will be pulled back due to several external factors such as the property cooling measures and global slowdown. However, there are still some bright spots in Singapore's loan market, such as building & construction and transportation loans, to help pick up the slack that is left behind by the mortgage loans. These two segments have seen rising loan growth since the start of 2018 despite total loan growth slowing down in 2H18 (Chart 6). Therefore, while we expect to see a slowdown in overall loan growth, we believe it will still be growing at a moderate rate of 5% - 6%.

Chart 6: Loans in certain sectors are still growing

According to the Building and Construction Authority (BCA), total construction demand in 2019 is expected to range from SGD 27 billion – SGD 32 billion and this will likely drive up building and construction loans in Singapore by a good 15% - 17%. We can expect sustainable construction demand as 60% of this demand will come from the public sector, with major projects such as the Changi Terminal 5. The majority of the remaining 40% will be from the redevelopment of successful en-bloc sites transacted between 2017 and 2018 , where we expect the loans to kick in by 1H 2019. With these upcoming new projects, it paints a positive outlook for building and construction loan growth for the Singapore banks despite the cooling measures.

Similarly, we see potential growth in transportation loans amidst the trade war, as Singapore continues to expand its land, airport and port operations. These will likely come in the form of more investments in technology in the transport industry to keep up the competitiveness. Such investments include automation and data analytics for greater efficiency and we believe these investments will help to drive up the transportation loan growth for the banks.

Table 1: Take-up rates on the first day of sales

Given that mortgage loans take up approximately 20% of the Singapore banks' loan portfolio, we would like to highlight that while mortgage loan growth in 2019 will remain soft, we expect demand from first-time buyers and displaced homeowners to cushion the growth of mortgage loan in 2019, given that they are less exposed to the cooling measures. On top of that, the take-up rates for recent private housing launches on their first day of sales (after the cooling measures) have displayed decent results as shown in Table 1. Hence, we believe that mortgage loan growth will still be positive, though at a slower rate.

Key investment risks

While we are positive on Singapore's banking sector, there are some investment risks to look out for. For instance, a further escalation in US-China trade war tensions could weigh on global growth prospects, and that will certainly have ramifications on Singapore's trade loans. With the latest round of property curbs also putting a ceiling on housing demand, mortgage loan growth this year could be lower-than-expected, especially if a fresh round of tightening measures are implemented.

The slowdown in Fed rate hikes is also another key risk to note, given its direct impact on the banks' NIM. While we believe that the Fed's gradual rate hike trajectory remains intact, any rate adjustment decisions remain data-dependent and if the economy and labour market show signs of weakness, it could give the Fed room to stop its rate hike cycle, or maybe contemplate a rate cut instead.

Attractive valuations with more than 15% upside potential

Our valuation is built on a fair PB ratio and based on our 2019 ROE estimates, it translates to a PB ratio of 1.5X, 1.4X and 1.4X for DBS, OCBC and UOB respectively. Using the PB ratio, we arrived at a target price of SGD 28.6, SGD 14.0 and SGD 30.0 as shown in Table 2. As such, we believe there is a potential upside of more than 15% for the three individual banks.

Table 2: Valuations of Singapore banks

Apart from their attractive upside potential, Singapore banks are also turning into yield plays, with their high dividends potentially lending support to share prices. The average forward dividend yield of the Singapore banks stands roughly at 4%, and the respective management has constantly reaffirmed their commitment to a steady and sustainable payment of dividends. Given that the average payout ratio of 50% is also at a healthy level, this should provide investors with adequate assurance that future dividends will be sustainable.

While investors can certainly invest in each of the individual bank, those who prefer to have a more diversified exposure to the Singapore banking sector can opt for the SPDR Straits Times Index ETF (SGX.ES3), which has a combined 40% exposure to DBS, OCBC and UOB. Apart from its low expense ratio of only 0.30%, the SPDR Straits Times Index ETF also has a better tracking difference and larger AUM base as compared to its peer.

DBS (SGX.D05) will be releasing their FY2018 results on the 18 Feb 2019 (Monday), followed by OCBC (SGX.O39) and UOB (SGX.U11) on the 22 Feb 2019 (Friday).

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.

The Research Team is part of iFAST Financial Pte Ltd.