A caution on the banks

Wednesday, April 2nd, 2014

Summary: That the “big four” banks account for more than a quarter of the total value of the sharemarket is living proof that they’re widely loved by Australian investors. But at existing price levels, and taking into consideration what could be perceived as a heightened risk environment developing for Australian banks, there is no margin of safety for purchasers of bank shares and a dividend yield of over 5% fully franked is required to compensate new investors.
Key take-out: Apart from the Commonwealth Bank, the majors are not excessively overpriced to the point where investors, particularly traders, could consider selling. Yet another surge in house prices and bank profits, without a general improvement in economic trends, would spell danger for bank shareholders.
Category: Shares.
ANZ Banking Group: Neutral.
Commonwealth Bank: Underperform.
National Australia Bank: Neutral.
Westpac Bank: Neutral.

The focus on yield by investors in the Australian share market can be explained by a number of factors. A key factor is that the taxation treatment of superannuation. The cash benefits of franking credits does ensure that Australian high yielding blue chip equities, particularly banks, will be highly sought by Australian retirees. However, there are other key observations that I would make about this unique period and it is the sustainability of the following factors that investors need to consider. These are:

  1. We have an ageing population and the wealthier older generation (which I define as baby boomers and older) are moving quickly into pension phase. They are seeking annuity cash flows to service their retirement needs (sustainable).
  2. We are living through an economic period where the international monetary policy settings are both unique and perverting. It is observable that international policy settings are holding Australian interest rates at historical lows for both mortgage borrowers and for bank depositors (not sustainable); and
  3. The yields on risk free assets, defined as long term government bonds, are also close to historic lows. For a period in mid-2012, real yields (i.e. adjusted for inflation) fell into negative territory. Today, real bond yields are positive but not by much. Therefore investors or savers are confronted by low yields across the maturity curve (not sustainable).

Figure 1. Australia and US 10-year government bond yields

Figure 1. Australia and US 10-year government bond yields
Source: Goldman Sachs Global Investment Research, Iress

Observations 2 and 3 above are symptoms of the unique and tedious low growth period following the GFC. This is an important observation because credit growth across the developed world remains tepid five years after the heights of the GFC. This period of low economic growth has restricted the asset growth of banks from Europe to the US and even in Australia. Investors need to understand that low asset or loan growth will ensure that profit growth of banks will be challenged. Arguably Australian banks have done remarkably well in challenging times, but Australia never suffered the downturn seen in offshore economies.

Today, the Australian economy is moving forward but with growth recorded at below longer term trends. With the closing of the resource capital investment cycle, the so called “transitioning” of the Australian economy and a tough fiscal response being suggested by the Commonwealth Government, I think that sub trend growth is a feature that will dog our economy for the foreseeable future. Further, the ageing population, rising unemployment and low interest rates all add to my view that consumption growth and thus the demand for credit will remain tested.

The one area of credit that is seeing growth is directed at housing lending and all the major banks are piling in here at a great rate. This concentration of growth does lead me to wonder whether our banks are taking on concentrated asset risk.

Outlook for Australian banks

Based on the above I reiterate my view, expressed over the last six months, that Australian listed banks are fairly fully valued at present. However, apart from the Commonwealth Bank of Australia (ASX:CBA), the majors are not excessively overpriced to the point where investors, particularly traders, could consider selling. Currently there is no margin of safety for purchasers and I would suggest that a dividend yield of over 5% fully franked is required to compensate new investors for what I perceive is a heightened risk environment developing for Australian banks.

The following table (Figure 2), extracted from StocksInValue.com.au, outlines the forecast valuations for the banks based on market consensus earnings. The table also illustrates a remarkable point that the combined value of our major banks is over $400 billion against a total market value of $1.5 trillion. That is my definition of too big to fail!

Figure 2. The Big Four banks

Figure 2. The Big Four banks
Source: StocksInValue.com.au

Readers should note that the forward values are based on a conservative required return inputs (RR) of about 11.5% but I maintain that this is appropriate for the following reasons:

Firstly, the Australian banks are trading in a remarkable period where private sector credit growth is well below long term trends. Indeed the current period is not dissimilar to recession period of 1991 to 1994.

Figure 3. Australian private sector credit growth

Figure 3. Australian private sector credit growth
Source: Goldman Sachs Global Investment Research, RBA

However, unlike that period twenty years ago before the “recession we had to have”, the corporate demand for credit remains low and corporate balance sheets are lowly geared. The larger Australian companies are persistently going around the banks to raise funding directly from corporate bond markets. Therefore, the banks are struggling to grow assets in the corporate sector and this has traditionally been a higher margin business then say traditional mortgage lending.

 Figure 4. Corporate gearing ratio

Figure 4. Corporate gearing ratio
Source: ABS, Goldman Sachs Global Investment Research

Investors should be aware that Australian banks are increasing profits but they continue to operate on lower interest margins and that is not a good trend.

Figure 5. Major bank’s net interest margin

Figure 5. Major bank’s net interest margin
Source: RBA, banks’ financial reports

The significant growth area for the banks has been in the mortgage market and it is well documented that there has been a surge in activity in the home building/lending sector following a near decade of sub optimal building activity.

Figure 6. Credit growth by sector

Figure 6. Credit growth by sector
Source: APRA, RBA

Whilst it is true that mortgage lending is considered a lower risk lending activity, this is exactly what was said of the US housing market to justify subprime lending from 2002 to 2007.

That leads me to the looming issue for investors who through index type investing are generally highly exposed to bank stocks. This issue is the observation that Australia has not succumbed to a recession or any reasonable downturn for nearly 22 years. Further what many young investors have not seen or may not recall is that the last recession decimated banks’ capital through a large lift in non-performing loans and resulting losses. Banks are highly leveraged entities and so their risk profile is actually quite high despite their size.

Figure 7. Banks’ non-performing assets

Figure 7. Banks’ non-performing assets
Source: APRA, RBA

Whilst I am not suggesting that a recession is looming, I am suggesting that the Australian economic environment has become unstable. The lack of an economic correction has resulted in a build-up of inefficiencies across the economy. This is illustrated by a growing fiscal deficit, static labour productivity, suboptimal returns on capital, high costs and inefficient work practices.

What many commentators have failed to appreciate is that these observations of poor economic trends are swamped by the perverse effects of offshore monetary policies. A high Australian dollar, low interest rates and ballooning house prices are not indicative of economic prosperity. Rather, they result from the appalling economic position that is occurring across Europe and Japan.

The difficulty in generating reasonable returns on equity (ROE) by the vast majority of Australian listed corporations actually results in their low demand for debt. Excluding the tail of the resource capital boom, the forward intentions of business investment activity has fallen to recession type levels. This actually restricts the potential of the Australian equity market to revalue from its current level of 5,400, and that corresponds to its level in April 2006!

Remarkably and despite the above observations Australia’s Big Four banks stand out in terms of ROE. Noteworthy is that they are much superior to those of regional banks. That should give bank shareholders some heart but I wonder about the sustainability of these returns in the face of rising unemployment and given that their provisioning for bad debts is at very low levels.

Figure 8. Bank profitability

Figure 8. Bank profitability
Source: RBA, banks’ annual and interim reports

A question to contemplate

I pose this question for yield and bank investors:

Given that our society’s wealth creation is very much dependent on residential property prices and so too is the profitability of our major banks, what would happen if Australia like every other developed country, encountered a period of declining house prices?

I pose this question not to be mischievous but rather to suggest that it my view it is rather quite bizarre that our society measures economic success by a general lift house prices rather than a lift in the general affordability of housing. If you do not think that it is a growing problem for our society than I suggest that you talk to your children. It is they who are asked to take on more and more debt so that an older wealthier generation can live off growing bank dividends. Maybe fairness does not matter but economics and markets have a way of correcting imbalances.

Today, I recommend holding banks but I suggest caution. Another surge in house prices and bank profits, without a general improvement in economic trends would spell danger for bank shareholders.

Clime Income Portfolio Statistics

Return since June 30, 2013: 15.48%
Returns since Inception (April 24, 2012): 45.08%
Average Yield: 7.22%
Start Value: $150,754.88
Current Value: $174,098.04
Dividends accrued since June 30, 2013: $8,172.58

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