Rate cut hopes crumble for non-banks as Citi downgrades lenders

Investors who bought shares in listed non-bank lenders on expectations of interest rate cuts later this year may be in for a nasty surprise.

Investors who saw a bargain in listed non-bank lenders due to their recent price dip, and who were banking on future interest rate cuts to boost their value, might want to adjust their bets, Citi says.

The US broker is downgrading Australia Finance Group and Resimac Group to “sell”, from “neutral” less than two weeks after also downgrading the banking sector to “sell”, leaving only neutral calls on Westpac and ANZ shares.

“We think it is hard to make a compelling case for the sector as expectations have run ahead of fundamentals,” Citi analysts said of the non-banks in a note sent to clients on Monday.

Citi notes the share prices of non-banks have high betas, meaning they tend to fluctuate more than the overall market, and have outperformed on the soft-landing narrative which sees the economy slowing down just enough to allow the Reserve Bank to start trimming interest rates later this year.

The expected RBA cuts, in theory, should help profitability since it would give lenders the opportunity to “reset” the interest rates they charge on mortgages to create higher margins. However, Citi analysts believe this will be difficult to achieve as both banks and non-banks are facing high competition and higher funding costs which are pushing mortgage spreads down.

“We think that their ability to outperform will come back to the earnings outlook — which looks difficult,” the broker wrote.

“A broad improvement in earnings is required to meaningfully drive the shares from here. However, given the almost structural shift in mortgage profitability, that looks difficult until well after the next rate cut cycle.”

“This doesn’t look to be a 2024 phenomenon, or indeed an early 2025 one.”

After underperforming in the last two years, shares in non-bank lenders such as AFG and Resimac have surged 17 per cent and 20 per cent, respectively, over the past three months. Pepper Money is the exception, with its shares down 4.6 per cent over the same period.

Downgrading AFG, Citi noted the company has historically traded at a premium to peers given the diversification benefits of its broking business, which didn’t require a lot of capital in the past. But, this is changing and the capital intensity of the industry is rising alongside competition.

“AFG faces a difficult juncture as depressed mortgage profitability subdues its lending business, while the economics in the broking business continues to shift towards the brokers,” the broker said.

“Arguably AFG’s underperformance since its 2H23 result reflects the rising capital intensity and pressure on its model. As such, AFG’s de-rating could continue as pressures persist through its reinvestment cycle, stretching out its share price underperformance.”

Justifying its downgrade on Resimac Group to “sell” Citi said the company’s concentration on the mortgage market left it at risk versus peers.

“Given the issues with mortgage pricing, Resimac’s near 100 per cent weighting in mortgages (about 50 per cent in prime mortgages) leaves it more susceptible to industry headwinds,” the broker said.

“While others (i.e. Liberty Finance Group and Pepper Money) have focused on diversifying into asset finance and SME, Resimac is further behind in its ambitions.”

The broker left its “neutral” call on Liberty intact and reiterated its “buy” call on Pepper Money, given “its wider valuation discount is increasingly harder to justify”.