Australia | Jul 27 2016
This story features COMMONWEALTH BANK OF AUSTRALIA, and other companies. For more info SHARE ANALYSIS: CBA
– Brokers suggest investment in Australian banks requires a new strategy in an unfamiliar environment
– Updated forecasts for Commonwealth Bank, Westpac, ANZ Bank and National Australia Bank
– New bank capital requirements
– bank earnings growth slowing
– bank dividends at risk
By Greg Peel
FNArena’s most recent bank update (What’s Ahead For Australian Banks? June 28) was published three trading days after the Brexit vote, at which point the ASX200, and Australian bank stocks, reached their lowest point before the bounce.
The plunge in bank shares meant that prior to any chance of a response from bank analysts, the gap to consensus target prices from trading prices had blown out to the mid-teens of percent for all bar Commonwealth Bank ((CBA)) which, due to its near perennial premium, showed only an 8% gap. That’s still sizeable for CBA.
At the time I noted that in FNArena’s experience, gaps of such proportion for bank shares invariably means one of two things follow. Either share prices rally or analysts drop their targets. Under the circumstances of what then looked like the sky was falling, I was leaning to a de-rating from analysts based on increased global risk in the sector.
Whether or not analysts were sharpening their pencils at that point we’ll never know, because the post-Brexit bounce that took everyone by as much surprise as the Brexit vote had done in the first place saw bank shares as a major leader. Here we are a month later, and as the following table shows, the price to target gaps are back in familiar territory, with the CBA premium intact.
The closing prices (yesterday’s) in the table above and thus the gaps to target have much reduced since the last table published on June 28. The targets are steady, and as a result so are the earnings and dividend and metrics. Yields, being based on share price, are back to where they were prior.
Well done to those investors who were bold enough to pick up the extra yield on offer when bank shares plunged. Because despite the fact Australia’s banks are only minimally exposed to the UK and EU regions, analysts agree the rally-back for the banks was driven by one thing and one thing only – yield.
Otherwise, Australia’s banks don’t have that much going for them at present.
Today’s bank operates in many and varied fields, from commercial banking through wealth management and life insurance, but at the end of the day a bank still lives and dies on its “net interest margin” – in simple terms, the difference between what it costs the bank to borrow money and what it can charge to lend that money.
A bank’s capital base provides the foundation to leverage its earnings potential (within regulations) by borrowing further funds, which it does so by taking deposits, and issuing debt, for example as convertible notes, locally and offshore. The bank then lends out that money into, in simple terms, three areas – retail banking, being mortgages through to personal loans and credit cards, business banking, being loans and facilities for businesses small and large, and institutional banking, being what was once called “corporate finance” – credit facilities, debt management, merger & acquisition management and so forth for large corporations.
Aside from any fees involved, the net interest margin (NIM) achieved from lending will determine the extent of a bank’s earnings. Bank NIMs have been falling since the GFC, and by all accounts are set to fall further.
Global interest rates are historically low and getting historically lower. In Australia, the RBA cut its cash rate in May to a historically low 1.75% and economists are expecting further cuts, perhaps all the way to 1.00%. If we hold the percentage NIM a bank seeks to achieve over its borrowing rate constant, mathematically the lower the prevailing interest rate, the lower the NIM.
Despite Brexit risk being shrugged off by the market, as the rebound in Australian bank shares suggests, the implications for UK and EU banks is that uncertainty, and thus risk, has increased. Australian banks may have little direct exposure to the region in the business they conduct but they do seek funding via debt issues to the region, as well as to the US. Increased risk reverberates globally, pushing up the cost of borrowing for Australia banks.
Far and away the bulk of Australian bank earnings are achieved in the mortgage market. Late last year the regulators clamped down on investment mortgages, fearing a housing bubble. This has limited the amount of mortgages the banks can write.
This limitation has led to fierce competition among the banks, which might seem incredulous to those who believe Australia’s Big Four are an oligopoly operating as a cartel. Steep discounts are being offered on mortgage rates to quality borrowers, further pressuring NIMs.
The same is true on the other side of the equation. Competition is fierce for term deposits.
And to top things of, Australia’s housing cycle is now at best maturing and at worst already cooling. While ever lower cash rates will offer demand support, ever higher house prices and runaway apartment development open up the risk of easing demand and excess supply. Were prices to begin falling, the next risk is increasing mortgage defaults.
It may not, therefore, be a great time for the banks to increase their base mortgage rates. But they have, including last year when the stiffer regulations prompted rate increases without an RBA cut, and in May, when the RBA cut. RBA cuts offer banks a backdoor means of “repricing”, as it’s called, by not passing on a full 25 basis point cut of mortgage rates. Analysts are assuming that any further RBA rate cut from here – which are expected – will lead to further mortgage repricing.
Mortgage repricing offers up three issues. The first is that bank analysts do not believe repricing will be sufficient to overcome all the other pressures on NIMs. The second is as suggested, that mortgage repricing offers some level of danger if the housing market is cooling. The third is that if the banks have dodged a bullet on pre-election calls for a Royal Commission into their activities (basically because Labor didn’t win), mortgage repricing will likely enrage a hostile Senate and possibly leave the slim-majority government with no choice.
Morgan Stanley’s analysts, for one, have trimmed their bank margin expectations and as a result, earnings forecast cuts of 2-3% across the sector follow. Morgan Stanley expects CBA to come under the greatest margin pressure of the Big Four. Deposit competition is a big risk for the regional banks, the broker suggests, but they are bigger beneficiaries from mortgage repricing (and would not be the target of a Royal Commission).
The bank reporting season in May confirmed what many a bank analyst had feared – while a still-growing Australian economy meant credit quality remained relatively strong on a net basis across bank loan books, “single name” borrowers and “pockets of weakness” in the economy led to the biggest leap in bad and doubtful debts (BDD) since the GFC.
And it was around about last year the banks brought the last of the BDD provisions they had hastily taken following the GFC back onto the books as earnings. The additional risk buffer the banks were carrying is gone.
The good news is that the leap in first half BDDs, for all of Westpac ((WBC)), ANZ Bank ((ANZ)) and National Australian Bank ((NAB)) was a bit of an anomaly. It’s not every half we see names like Dick Smith, Slater & Gordon, Arrium and Peabody (Australia) hit the wall at the same time. The bad news is the “pockets of weakness”, such as the mining states and the New Zealand dairy industry still linger, and a new potential “pocket” is looming in residential apartment developers.
But overall, feedback suggests to Morgan Stanley broader Australian credit quality remains resilient as 2016 progresses.
This goes some way to alleviating the risk of earnings losses for the banks, but does not provide for actual earnings growth.
Earnings and the New Paradigm
The greatest concern Australian investors have at present with regard the banks is capital. This is evidenced by the fact forecast yields are still in the order of 6% (plus franking) despite an RBA cash rate of only 1.75%. Investors fear dividend cuts and/or capital raisings, both of which reduce the yield on shares already held.
The expectation of increased capital stems from expected, but as yet unquantified, increases to capital requirements from both international and domestic regulators. Not all bank analysts believe the banks will be forced to raise fresh capital, but then not all believed they would before last year’s round of raisings. All believe, however, there is a clear risk to dividends.
Aforementioned BDD provisions taken by the banks amidst GFC-related capital raisings in 2009 proved, thankfully, not to be needed as time wore on. Thus as time wore on, the banks handed those provisions, taken from earnings, back to investors in the form of ever increasing dividend payout ratios and the odd special dividend. As noted, there are no longer any excess provisions (beyond what a bank would normally hold) left in the coffers.
Those dividend payout ratios remain elevated for all the majors bar ANZ, which bit the bullet in May. There was much relief when NAB and Westpac didn’t follow suit, although analysts suspected those two were only delaying the inevitable, while CBA has its chance to react next month.
A lack of earnings growth, driven by the aforementioned pressure on NIMs, means the banks will have to do something about their capital positions if regulations force their hands.
Morgan Stanley was one broker predicting last year’s capital raising, and again the broker is expecting a further round sooner rather than later. Citi believes the new requirements will be “manageable”, but suggests that to be relaxed about capital is to ignore the risks to core earnings growth.
“Investing in Australian banks is set to change profoundly” said Citi in a recent note.
Since the GFC, the most successful investor strategy was to own the Big Bank with the most direct access to the higher growth, higher return mortgage market, Citi notes. But given assumed increased capital requirements, and “maxed out” dividends, the pressure is on revenues and earnings. With the mortgage market maturing, Citi believes the banks must now “manage their franchises differently”.
In order to counter all the aforementioned pressures on NIMs, the broker believes the banks will have to become more disciplined and rigorous on cost management, must scale back their institutional businesses (where earnings are weakest at present), and “recalibrate” wealth management ownership, which is code for outsource into a joint venture or simply sell out altogether.
Given a more subdued outlook, Citi suggests investors would now be best served by investing in the lowest rated bank, not the bank with the most direct access to the higher growth, higher return mortgage market. The broker suggests that so far, ANZ has adopted best to the new paradigm (being the only bank to date to cut its dividend and begin a restructure) and this is not being recognised by the market.
NAB has also restructured insomuch as it has finally cut Clydesdale Bank loose (and just in the nick of time) but now the bank must focus on cost growth, Citi suggests. The premiums afforded the big mortgage lenders Westpac and, to a greater extent, CBA, may not remain intact.
Before investors get all excited by this new strategy suggestion form Citi, it might be best to consider some recent research by Deutsche Bank.
That research indicates that holding the bank with the lowest PE of the four is a strategy that ultimately has underperformed over the last one, three, five and ten year timeframes. The best strategy has been to hold the highest PE bank.
Deutsche last conducted such research in 2006, at which point the conclusion was the opposite. That makes sense, given there’s little doubt the GFC changed the very nature of bank investment.
Yet if Deutsche extends the timeframe all the way back to 1992, the most successful strategy has been to buy the “worst performing” bank in each quarter, as determined by total shareholder return. The least successful strategy has been to buy the best performing bank.
So to conclude, the best strategy post-GFC has been to buy the highest PE bank. The best strategy over the long term is to buy the worst performing bank. Deutsche’s current top pick among the majors is Westpac.
Deutsche also notes that a successful long-term strategy has been to buy the bank brokers like the least. Deutsche is a broker.
When ANZ stood alone in cutting its dividend back in May, its shares were duly punished. The punishment didn’t last long, because the RBA then cut its cash rate, allowing for another round of mortgage repricing and easing the pressure on those elevated BDDs. All the banks rallied thereafter.
Before the RBA made its move, ANZ’s sell-off was not as drastic as it might have been. Macquarie has correctly flagged this possibility at the time by noting, prior to bank results season, that short positions held in the banks had become unusually high. This would suggest those in the market with shorting capabilities were preparing for dividend cuts.
Since May, retail investors have once again been drawn to the banks, the data shows, which Macquarie puts down to the search for yield. Those short positions have been unwound back to more normal levels. This leaves bank share prices vulnerable to dividend cuts once more, with Macquarie believing NAB is the most likely candidate.
But NAB, ANZ and Westpac won’t report again until November. CBA, however, reports next month. Macquarie notes the net short position in CBA has been drifting up recently.
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