Feature Stories | Mar 23 2017
This article was first published for subscribers on March 15 and is now open for general readership.
Housing bubble bursts? Fed hikes rapidly? Australia loses its AAA rating? Regulators tighten the screws? With all that is potentially facing Australia’s major banks, are they overvalued?
– Historically high PEs
– Low earnings growth
– Numerous risks
– Relative support
By Greg Peel
“Macquarie pulled its sector view back to Neutral. UBS is currently maintaining a ‘relatively neutral view’. Deutsche Bank suggests the brighter outlook is ‘largely in the price’. Morgan Stanley notes Australian bank valuation metrics look elevated compared to history. Last week Citi declared quite boldly ‘sun to set on bank share price rally’.”
This is an excerpt from FNArena’s last update on Australia’s major banks published in January (Australian Banks: Valuations Stretched). As can be concluded from this selection of broker views, a further rally in bank share prices was not deemed likely.
On a simple price average basis (not cap-weighted), bank share prices are now 3% higher.
What has happened in the meantime? Well not much more than a first half earnings report from Commonwealth Bank ((CBA)) and first quarter updates from ANZ Bank ((ANZ)), National Bank ((NAB)) and Westpac ((WBC)). The Trump effect had already pretty much been priced in back in January, leaving the mildly better than expected bank results in February, and no dividend cuts or talk of capital raisings, as reasons investors saw fit to ignore brokers.
Probably the biggest difference is that brokers have now been forced to temper prior views about increasing bad debts – these proved to be benign. There was also much wailing and gnashing of teeth over the potential for an apartment-led bursting of the housing bubble, but so far that hasn’t happened. But we have seen the regulators again becoming concerned over house prices, and a renewed growth spurt in investor mortgages and overall household debt. And Standard & Poor’s stands ready to downgrade Australia's sovereign rating from AAA, which implies a flow-on downgrade to bank credit ratings.
On the other side of the equation, banks continue to face little more than a subdued earnings growth environment. With so many risks in the offing, are bank valuations now even more overstretched?
It’s hard to escape the constant headlines. Given a prior undersupply of housing in Australia, strong immigration-assisted population growth, a stampede of foreign buyers, mostly Chinese, unquenched investor interest in property, and soaring house prices, property developers have been madly throwing up apartment blocks like there’s no tomorrow, mostly in Sydney and Melbourne. Surely this boom cannot continue?
It can’t continue forever. Indeed, there are already signs of cooling with only Sydney still in an upswing, according to analysts, and then not for too much longer. The real question is whether “cooling” implies “bust”, and if so, what are the ramifications for those institutions lending the money to both the developers and the buyers of apartments?
Over the last twelve months, note the bank analysts at Citi, the major banks have tightened liquidity, meaning successive new apartment projects are finding it more and more difficult to access finance. Many have turned to other sources of finance and funding structures, which should offer bank shareholders better loan loss protection in future years, Citi suggests.
If we were about to face any sort of apartment bust, this would be showing up by now in increasing settlement defaults from buyers. This is what the market has been expecting, perhaps best evidenced by the example of leading apartment developer Lend Lease’s ((LLC)) share price underperformance from the new year, when “bust” fears were rife, through to the company’s earnings result release. That result highlighted negligible defaults to date – basically as many as one might expect on average. Lend Lease’s share price has done nothing but rise ever since.
Of course, Lend Lease is not the only player in town, and as Citi notes, there has been anecdotal evidence of isolated projects with stressed levels of defaults, and often times-to-settlement have been extended. However, all the analysts can go on to date are anecdotes. There is nothing concerning coming through in the data as yet.
Then there’s the question of just how bad things have to get before investors should start dumping their shares in the banks that lend money to both the developers and the buyers. On that note, Citi’s analysis suggests that a “very high level” [Citi’s emphasis] of defaults is required to have any meaningful impact on the banks. The majors are protected to an extent by other capital providers who, in exchange for very lucrative internal rates of return, take on board the majority of settlement risk.
Citi may be not overly worried but the regulator, APRA, is again having trouble sleeping at night. The source of insomnia is a return to growth in investor mortgages.
When “housing bubble” concerns began building last year, APRA enforced a 10% growth cap on bank investor loan books. Banks responded by tightening their lending requirements, thus reducing demand and slowing growth. It worked. Investor loan growth slowed, APRA was happy, and the RBA also let out a sigh of relief.
But they’re back.
Investor loan growth may have slowed for a few months but house prices did not stop rising. Recently the Trump rally has revived the stock market to some extent but realistically the Australian stock market on a net basis has gone nowhere in the past several years. Within the stock market, those stocks previously popular with investors for their high yields were unceremoniously dumped towards the end of last year on fears of rising global rates (Fed-led) and a switch back into the resource sector.
Where does a retiree put one’s money? Property looks good.
Earlier in the month, APRA chairman declared “Strong competitive pressures are producing higher rates of lending growth again…We therefore see no room for complacency”. The implication is the banks have loosened the purse strings once more. To that end, Morgan Stanley’s bank analysts would not be surprised if APRA were to readdress the 10% loan growth cap.
What if APRA reduced the cap to 5% growth for investor loans? Morgan Stanley calculates the majors would actually have to reduce their investor loan growth to around 4% to offset around 6% in owner-occupier loan growth. Total housing loan growth could fall to 5%, the analysts suggest, from a current 6.5%.
Looking at the past sixth months’ data, CBA’s and Westpac’s investor loans are currently growing in excess of 5%, Morgan Stanley observes, NAB is at about 5% and ANZ is below.
Were the banks forced to scale back their lending further, the offset from an earnings perspective would be to again reprice their mortgage rates. Since the beginning of 2016, the majors have collectively repriced owner-occupier rates by 15 basis points and investor rates by 28 basis points, Morgan Stanley notes, or 20bps net across loan books. With little opportunity to expand net interest margins elsewhere, and loan demand remaining strong, the banks are likely to continue repricing in 2017, the analysts believe.
But it’s fine line. Reprice too far and the risk is demand will reduce and loan growth will slow.
Not So Bad
The long-running cyclical downturn in banks’ bad and doubtful debts (BDD), following from the GFC, ended a couple of years ago. Since then bank analysts have been forecasting a cyclical swing back up in BDDs, particularly as areas of the Australian economy are under pressure and relevant states are still suffering from the end of the mining investment boom. But so far, the upswing has been mild.
This hasn’t stopped analysts assuming that BDDs must cycle back towards a long running average and as such each reporting season this view is reflected in forecasts. Yet as CBA reported last month, and the other three provided updates, still there is no sign of such an increase. Bad debt expenses were much lower than expected in the December quarter, Deutsche Bank notes.
There are a couple of individual explanations. A year ago, commodity prices and the price of milk were collapsing. This led to specific loan risk in the areas of direct mining, being the ones using the shovels, indirect mining, being the ones providing the shovels and other services, and New Zealand dairy. We must not forget the NZ in ANZ along with the presence of the other three across the Ditch. A year on, things are different.
Commodity prices have rebounded strongly and milk has bottomed out and stabilised. Improvements have been seen in direct mining and NZ dairy and while indirect mining remains under pressure, Deutsche Bank sees these loans as manageable at this stage. Deutsche’s analysts have reduced their BDD assumptions in the near term but continue to maintain an assumption of a gradual increase to FY19.
Yet it was not just bad debts that were surprisingly low in the period, it was doubtful debts, being those borrowers in arrears or at risk. Doubtful is a step towards bad. Both Westpac and NAB saw a reduction in stressed NZ dairy loans. Westpac saw a significant reduction in stressed loans to direct mining. Indirect mining nevertheless remains stressful for Westpac, including the flow-on to WA mortgages.
Despite the relatively benign scenario for BDDs, ratings agency Standard & Poor’s continues to warn that rising imbalances in the Australian economy could pose a risk to bank credit ratings. A ratings downgrade implies a risk upgrade, meaning wholesale lenders require a higher risk premium. The banks would have to pay more for funds.
Bank credit ratings are at risk on two fronts – individually, and in connection to Australia’s sovereign rating. S&P has also sounded warning bells with regard Australia’s AAA rating, one of few in the world (the US is AA+, the UK AA), citing rising debt levels and the lack of any fiscal policy effort to address it. Given the Little Shop of Horrors we call parliament is unlikely to find common ground on any policy reform, if only for the sake of being adversarial, change seems unlikely on that front. Fortunately the commodity price rebound has bought the government some time.
It is a general rule, albeit not mandatory, that if a country’s credit rating is downgraded the ratings of its major banks are also downgraded by default. However, Deutsche sees the possibility of the banks avoiding downgrades even if the country loses a notch. It all comes down to S&P’s measure of risk-adjusted capital (RAC), which includes both tier one capital (equity) and hybrids (convertibles) and applies different risk adjustment metrics to those of APRA.
Deutsche notes that the line in the sand is 10%. Above this level, it would be possible for a bank to avoid a downgrade even in the event of a sovereign downgrade. Currently the majors are sitting on S&P RACs of 7-10%. Westpac is very close to 10%. All the banks are slowly growing their capital.
It then becomes a matter of timing. If S&P holds off on a sovereign downgrade, then one or more of the majors could sneak across the line in the meantime, Deutsche suggests.
That said, the analysts also suggest a one notch tick down in credit rating is not the end of the world. The additional funding cost imposed would amount to a -1.6% loss of profit on average for the majors. And that loss would be spread across ten years.
The Case For
Over the past six months, the banks’ average share price to one-year forecast earnings ratio (forward PE) has risen from a long-run average of around 12x to around 13.5x. Thus one might say, in absolute terms, the banks are overvalued.
However, the market PE is also running above average, and indeed the banks are trading at a -5% discount to industrials. This would make them cheap on a relative basis.
A relative basis is important for fund managers who must own stocks. Passive fund managers simply own the index by market cap weighting, whereas active fund managers can choose to overweight and underweight certain sectors or stocks. If the banks are indeed undervalued, they are thus attractive compared to other sectors of the market.
An absolute basis is more relevant to the individual investor, who chooses to own stocks or not own stocks, perhaps preferring term deposits as an investment alternative or, dare we say, investment property. If the banks are indeed overvalued, then perhaps now is not the best time for individual investors to be buying them. Except, of course, if fund managers are buying them, in which case you might as well get on board.
But should you?
Deutsche Bank says yes, and has raised its rating on the sector to Overweight from Neutral. The Deutsche equity strategists cite six reasons for their call.
The first is the above-noted PE discount to market.
The second is that after two years of underperformance versus industrials, bank earnings appear to have bottomed. It is true earnings growth is much lower than the historical average, Deutsche admits, but the same is true for the rest of the market. (Hence a relative call.)
Thirdly, the prospect of higher global interest rates (the market expects a Fed hike tonight) should be supportive for Australian banks on two fronts: Australian bank valuations tend to ride on the coat tails of US bank valuations, which benefit from rising rates; and rising rates make Australia’s high yield plays (utilities, telcos etc) less attractive as alternatives to solid bank yields.
Fourthly, as has been discussed, bad debts are subdued and will likely remain so for the time being, Deutsche believes, given market earnings are improving rather than declining.
Fifthly, these five reasons are being offered by Deutsche Bank’s strategists, or “top-down” evaluators, as opposed to Deutsche’s bank analysts, or “bottom-up” evaluators. These two tribes in any stockbroking firm get on about as well as The Cove and the Red & Black Block. The strategists note that across all brokers, there are currently far fewer Buy ratings and many more Holds and Sells on the banks than usual.
Historically, the strategists note, “this has been positive for share price performance”. For the record, Deutsche’s own analysts have two Buys and two Holds.
Finally, regulatory risk is easing. Given no agreement has yet been reached, Basel IV capital requirements will likely be both watered down and the compliance timeframe pushed further out. APRA will still potentially add its own additional buffer requirement, but even APRA has more recently played down likely extent and timeframe.
This means the risk of the banks needing to raise more capital is diminished on two fronts – actual extent of requirement and the time banks would have to meet new requirements anyway. This further suggests less risk of required cuts to dividends, and to the banks having to engage in another deposit war.
The Case Against
Morgan Stanley agrees the regulatory factor has meant pressure has eased on bank valuations.
Morgan Stanley’s analysts also note higher house prices have supported loan growth, mortgage repricing has offset margin pressures in other areas of banking, the commodity price rebound had eased BDD risks in that sector, and the global “reflation trade” (See: Donald Trump) has boosted banks’ trading income.
But Morgan Stanley suggests these positives have led the banks only to a “fragile equilibrium”. There are a number of challenges on the horizon.
They might be benign right now but there remains a risk of rising BDDs. The battle to attract deposits continues, squeezing margins. As house prices rise, there is a greater risk APRA will tighten the screws once more, leading to reduced loan demand. Any move to reprice mortgages in order to slow loan growth in compliance with APRA’s requirements would boost margins but also impact on demand. As noted, the banks are facing a possible credit rating downgrade. Weak wages growth across the economy, largely reflecting the balance of part-time to full-time employment, offers up the risk of deteriorating credit quality, which brings us back around to BDDs once more.
At the current forward PE of 13.5x, Morgan Stanley believes the banks are “priced for a sweet spot”. By any other measure they are not cheap either – earnings growth is low, return on equity measures are falling, and dividend payout ratios are stretched. On the analysts’ calculation, to restore bank valuations to long-run average PE levels would require some 13% average upgrade to FY18 earnings forecasts.
To achieve this would require increased net interest margins, stable BDDs and the neutralisation of dividend reinvestment plans for the next three dividends. (DRPs increase a bank’s share count and thus dilute earnings per share. The bank can “neutralise” dilution with a corresponding share buyback).
Higher margins and stable BDDs would require a “much improved economic outlook”, the analysts suggest, leading to rising interest rates, stable home loan growth, lower-for-longer loan losses and no further capital requirements.
Plausible, Morgan Stanley admits, but still unlikely.
Deutsche Bank’s strategists point out the ratio of Buy ratings to Holds and sells among bank analysts is historically low, suggesting share price upside on a contrarian basis. While FNArena is very familiar with the concept that if everyone is bearish on a stock it will likely rise (and vice versa), as suggested by analyst ratings, when it comes to banks there’s a contrasting rule with regard analyst price targets.
As is evident on the table below, the eight major broking houses on the FNArena database have between them nine Buy ratings across the four banks, nineteen Holds and four Sells. Back in January, prior to result season when bank share prices were lower, that ratio was 10/18/4. Not a lot of difference.
But what is most notable is that back in January, share prices and consensus target prices were all but matched for all of ANZ, NAB and Westpac. CBA was trading 4% above target but then CBA perennial carries a premium that bank analysts to this day struggle to justify, despite the fact it is as good as set in stone.
Now we see every bank trading above target, by 4-6%. That is why analysts ratings lean to Hold rather than Buy. In FNArena’s experience, bank share prices never remain above target for very long. Either analysts have to lift their targets or share prices have to pull back.
Lifting targets would require an improved earnings outlook, which would require a stronger economic outlook and/or a reduction in the various risks outlined above: regulatory, credit rating, bad debts, housing bubble and so forth.
But then there’s those 5-6% fully franked yields.
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