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Aussie Banks & Unintended Consequences

Always an independent thinker, Rudi has not shied away from making big out-of-consensus predictions that proved accurate later on. When Rio Tinto shares surged above $120 he wrote investors should sell. In mid-2008 he warned investors not to hold on to equities in oil producers. In August 2008 he predicted the largest sell-off in commodities stocks was about to follow. In 2009 he suggested Australian banks were an excellent buy. Between 2011 and 2015 Rudi consistently maintained investors were better off avoiding exposure to commodities and to commodities stocks. Post GFC, he dedicated his research to finding All-Weather Performers. See also "All-Weather Performers" on this website, as well as the Special Reports section.

Rudi's View | May 16 2018

In this week's Weekly Insights:

-Aussie Banks & Unintended Consequences
-Conviction Calls
-Rudi Talks

-Rudi On TV
-Rudi On Tour

-At The AIA Conference

Aussie Banks & Unintended Consequences

By Rudi Filapek-Vandyck, Editor FNArena

The easiest way to judge how companies are performing in Australia is by comparing stockbroker price targets before and after the release of financial results. It's a pretty straightforward measure and cuts out all the noise about one-offs and taxes, currencies and good/bad management and execution.

Cloud accountancy software provider Xero released its FY18 financial report on Friday. Price targets went up. Property listings platform REA Group updated on the March quarter. Price targets went up. The same happened for News Corp, though that was largely REA-inspired. After Macquarie Group released their financial report on the Friday prior, price targets jumped.

In most cases, however, price targets declined in the first two weeks of May indicating all is not going smoothly beneath the surface of rallying share prices and ongoing expectations for robust economic growth domestically. Incitec Pivot. Down. Orica. Down. Pendal Group. Down. Perpetual. Down. Village Roadshow. Significantly Down.

And the banks? Every single one has seen price targets decline this month on the back of either financial results or, in the case of CommBank ((CBA)), a quarterly trading update. Many a commentator continues to point at "cheap" valuations for the banks in Australia -all the banks, except Bendigo and Adelaide ((BEN))- and certainly that would seem to be the case given most share prices are trading below consensus price targets but maybe not as far off as one would be inclined to assume; between 6-8.5% for the Four Majors.

Yet, the observation remains banks are finding it difficult to participate in the broad based market recovery, regardless of all the value calls, the fact that cheap looking laggards have been regaining investor interest, and the fact most banks are paying out above market half-yearly dividends this month.

Clearly, something else is going on and it's not just about ongoing despicable embarrassments at the Royal Commission.


Sector analysts at IBISWorld, widely known for their specialised sector research reports such as on retail spending and new trends in consumer electronics, published their initial findings on Monday about what most likely lays ahead for the sector once thought of as the closest thing to God by Australian investors (but no longer).

On their assessment, Australian banks will be hamstrung with higher capital requirements, tighter regulation, and higher costs as a result of the public outrage about their misconduct in years past, and the regulatory and political scrutiny that follows as a result. While IBISWorld suggests higher costs will at the very least be partially passed on to clients, the sector analysts now forecast declining revenues for the sector over the next five years.

Another consequence of the Royal Commission should be tightened standards for lending to investors, consumers and businesses, suggest the analysts. While this opens up a drive for increased market share by smaller competitors, including non-bank lenders, this will also have consequences for credit growth in general, which closely intertwines with economic momentum and house prices in Australia.

If anyone wonders why the team of banking analysts at UBS retains a negative outlook for the banks overall, there's no need to search any further.


UBS's negative view on banks has consequences for the broader domestic economy with the house view fearful that tighter credit is likely to lead to weaker house prices with a flow on impact on household sentiment through a fading of the so-called wealth effect that stems from positive momentum for property prices.

No surprise thus, UBS thinks most GDP growth forecasts by economists elsewhere are likely to prove too optimistic, including the 3% maintained by the Reserve Bank for 2018. UBS suggests 2.75% is more likely, and this will keep the RBA on hold until the second half of 2019.

In a separate analysis, UBS' economists suggest tighter public scrutiny in Australia has the potential to spread out to New Zealand, where authorities already are taking notice. This could translate into yet more pressure for Australian banks who also dominate across the Tasman.

While further tightening of credit in New Zealand would add more downside risks for house prices and consumer spending in the country, and potential for bad debts to rise, an equally intriguing observation can be made from the graph below, taken from that same UBS report on Australian banks in New Zealand.


What the graph clearly shows is that tightening by banks has an almost immediate impact on house prices where there is elevated momentum (Auckland), and that a softening in lending standards once house prices are falling, takes a lot longer to then stabilise the market.


An equally insightful analysis was published by the team of economists at JP Morgan last week. Banks have let their standards slip, as was revealed at the Royal Commission, and sector regulator APRA has already instructed banks to set limits on new loans in high debt- and high loans-to-income categories, in industry parlance known as DTI and LTI loans.

With aggregate household debt in Australia rising to 189% of disposable income, many including the RBA and APRA have kept a close watch on this particular segment of banking loans. JP Morgan believes now that banks are being forced into more conservative lending practices, the potential fall-out is nothing less than "significant", and likely underestimated by all and sundry.

The reason is that, on JP Morgan analysis, a big chunk of the positive momentum in house prices in recent years stems from investor-borrowers, and there appears to be a direct link to higher LTI loans with both sellers and buyers in this particular bracket enjoying high LTI mortgages.

JP Morgan is predicting credit growth slowing from 6% annualised to 4% over three years. This seems like a gradual, relatively small contraction, but the economists are explicitly concerned it might represent a much more significant impact. Consider the following maths: High LTI loans represent around 10% of total volume in new loans, but because of their above average size, JP Morgan believes these loans represent maybe 31% of all new lending in dollar terms.

Restrict new high LTI borrowing and current sellers will be forced to negotiate with lower LTI buyers, suggesting downward pressure on prices. For good measure: JP Morgan is by no means predicting a crash in house prices in Australia, but merely a noticeable slowdown in overall activity, which translates into lesser demand for credit. A crash requires forced sellers, remind the economists.

What all this boils down to is that the outlook for banks has not looked as clouded since the global financial system froze in 2008, and this is understandably turning the sector into one of the major laggards in the local share market. See also "Middle Class Poverty? Blame The Banks" in last week's Weekly Insights.

Investors holding shares in discretionary retailers better prepare for tougher times ahead. This is a slow going, long drawn out process and with little in the way of a sizeable increase in average wages, I'd be inclined to think the overall landscape for consumer spending can remain subdued for a lot longer than the optimists might be willing to consider.

Conviction Calls

Anyone feeling an urge to get overly excited about future potential for the Australian share market should have a read through Morgan Stanley's assessments on the Australian economy. It's akin to standing underneath an icy cold shower with no clean towel in sight.

Post a Federal Budget that, we noticed, got a few market bulls excited about a potential pick up in consumer sentiment, the four equity strategists at Morgan Stanley have responded by pointing out any tangible improvement from the Budget on household incomes won't be forthcoming until 2020 and even then it'll be closer to "negligible" than to "material", while in the meantime an emerging $4bn headwind is building from higher petrol costs in 2018.

That'll easily eat away that fleeting Budget improvement the bulls are referring to.

Read between the lines and what the four at Morgan Stanley are suggesting is that by the time Australian households end up receiving a small income bonus from new tax cuts, the extra money will merely function as a band aid for ongoing pressures building for Australian households' spending power. This still is not a wonderful time to run a retail franchise.

Interestingly, the investment bank's US economics team has calculated about one-third of US income tax cuts shall be withered away by today's gasoline prices. That still leaves two-thirds to prop up US GDP growth. Not so in Australia, thus, where Morgan Stanley sticks with GDP growth of no more than 2% for 2018; well below both market consensus (2.7%) and the RBA (3%).


The Mid-Year Global Strategy update from US strategists at Morgan Stanley can probably be best described as "sobering". The 60 page report tries to convey the message that valuations for equities are far from cheap, while natural (and obvious) tailwinds for the asset class are now receding. The underlying message: things will only get harder from here onwards.

The strategy report's key sentence is probably the following one: "We think global equities are in a range-trading regime with limited 12-month upside". US ten year bond yields have no support above 3%, say the strategists, implying a flattening curve as the Federal Reserve remains intent on further normalising interest rates.

Key calls: Overweight European stocks and global energy equities, JPY to hit 95 by 3Q19, US Treasuries 10yr yields to end the year lower, with a flatter curve. Strong 12 month gains for the South African Rand and the Brazilian Real.

Base case forecast for the S&P500 in the US remains 2750 and that's not that far off from where the index is heading in the current rally.


Market strategists at UBS are equally as unenthusiastic about the outlook for Australian equities. While the local share market has bounced strongly from its lows in March, UBS cannot see it stretching out much further, while noting Australian equities have proved very adept in underperforming their foreign peers in years past and UBS doesn't see any reason why this should all of a sudden change.

Weaker earnings growth is the answer, in case you struggled to justify UBS's scepticism.

Portfolio-wise, UBS strategists remain Overweight mining and energy stocks, while having downgraded banks to Underweight from Neutral.

New Model Portfolio additions are Domino's Pizza ((DMP)), Downer EDI ((DOW)), Seven Group Holdings ((SVW)), and Vicinity Centres ((VCX)). Only one constituent has been removed: Westpac ((WBC)).

UBS's Model Portfolio's key Overweight positions are: AGL Energy ((AGL)), Aristocrat Leisure ((ALL)), BHP ((BHP)), Iluka Resources ((ILU)), Janus Henderson Group ((JHG)), Macquarie Group ((MQG)), Origin Energy ((ORG)), Seven Group Holdings, Star Entertainment ((SGR)), and Woodside Petroleum ((WPL)).


Macquarie strategists too have remained rather sceptical about any boost for consumer spending exposed sectors in Australia. Tax relief for low and middle income earners will arrive in the form of a non-refundable tax offset, points out Macquarie. If there were to be lumpy spending after Australians complete their tax return, it simply won't be enough to make a serious difference in an $1.7trn economy.

Consumer spending, predicts Macquarie, will continue to muddle along due to high household debt and low growth in wages, and that's not taking into account ongoing risks.


Strategists at Citi have now added Orora ((ORA)) and Suncorp Group ((SUN)) to the Citi Focus List Australia/NZ. Both stocks replace ALS ltd ((ALQ)) and Goodman Group ((GMG)) which have been removed.

Remaining constituents of Citi's Focus List are Aristocrat Leisure, Lend Lease Group ((LLC)), Newcrest Mining ((NCM)), NextDC ((NXT)), Qantas Airways ((QAN)), Rio Tinto ((RIO)), Star Entertainment, and Trade Me Group ((TME)).


Market strategists at stockbroker Morgans seem to be drinking from the same well as their peers at Morgan Stanley. The following sentence from their recent strategy update sums it up nicely: "There's no doubt after a strong 2017, conditions going forward may be more challenging at the macroeconomic level and we remind investors to remain vigilant".

Rudi Talks

We have added 2x more instalments of The Unfair Advantage.

One on yield investing in the Australian share market and one on Premium Quality, High PE stocks, and whether they are due for a fall:

Both videos can also be accessed directly through the website. See FNArena Talks, The Unfair Advantage.

Rudi On TV

This week my appearances on the Sky Business channel are scheduled as follows:

-Tuesday, 11.15am Skype-link to discuss broker calls
-Friday, 11am, Skype-link to discuss broker calls

Rudi On Tour

-Presentations to ASA members and guests Gold Coast and Brisbane (2x), on 12 & 13 June
-ATAA members presentation Newcastle, 14 July
-AIA National Conference, Gold Coast QLD, June 29-August 1
-Presentation to ASA members and guests Wollongong, on September 11
-Presentation to AIA members and guests Chatswood, on October 10

At the AIA Conference

As stated in the overview above, I will be presenting at the AIA National Annual Conference at the Marriott Resort and Spa Surfers Paradise, from 29th July til 1st August 2018.

This year's theme is SYNCHRONICITY, Identifying opportunities in a world growing in sync…

 For the first time in over a decade, the world’s major economies are growing in sync.

What does a world that is structurally awash in capital look like?

What will it mean for investors?

(This story was written on Monday 14h May. It was published on the day in the form of an email to paying subscribers at FNArena, and again on Wednesday as a story on the website).

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website.

In addition, since FNArena runs a Model Portfolio based upon my research on All-Weather Performers it is more than likely that stocks mentioned are included in this Model Portfolio. For all questions about this: or via the direct messaging system on the website).



Paid subscribers to FNArena (6 and 12 mnths) receive several bonus publications, at no extra cost, including:

– The AUD and the Australian Share Market (which stocks benefit from a weaker AUD, and which ones don't?)
– Make Risk Your Friend. Finding All-Weather Performers, January 2013 (The rationale behind investing in stocks that perform irrespective of the overall investment climate)
– Make Risk Your Friend. Finding All-Weather Performers, December 2014 (The follow-up that accounts for an ever changing world and updated stock selection)
– Change. Investing in a Low Growth World. eBook that sells through Amazon and other channels. Tackles the main issues impacting on investment strategies today and the world of tomorrow.
– Who's Afraid Of The Big Bad Bear? eBook and Book (print) available through Amazon and other channels. Your chance to relive 2016, and become a wiser investor along the way.

Subscriptions cost $420 (incl GST) for twelve months or $235 for six and can be purchased here (depending on your status, a subscription to FNArena might be tax deductible):

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions.)  

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