Portfolio Manager – Direct Equities, AMP Capital
Australia’s recent reporting season has revealed stalled profit growth for a majority of banks, accompanied by a fall in asset quality. In this article we look at what’s causing the decline in growth, strength in fundamentals despite weakening profits, and subsequent valuations and sentiment within this sector.
Bank earnings topping out: dividends may be trimmed
The recent reporting season highlighted many of the concerns we expressed about the banking sector in our 2015 update. Across the board, the majority of banks saw profit growth stalling and asset quality fall, driven by poor performance in resources-related business and institutional lending. With the market slowly realising the period of record profits and high dividends is coming to an end, valuations of Australia’s ‘big four’ banks – the Commonwealth Bank, Westpac, National Australia Bank and ANZ – have begun to converge lower towards their global peers in recent months.
Offsetting this is the Reserve Bank of Australia (RBA), which recently cut the cash rate to a record low of 1.75% – this should support debt affordability and asset quality. The sector will also benefit from the valuation support given to stocks with high dividends in a yield-starved world and the sector’s price/earnings (P/E) ratio that is now the lowest in our market. Overall, we think pressure on the sector will continue – investors need to acknowledge the changed environment and review their positions in the sector. The banks represent a large proportion of retail direct equity holdings, so clients need to be more prudent about the extent of their holdings in these names and take profits by trimming back oversized positions.
Profit growth drivers in the sector beginning to fade
The big four banks have been top global performers (in Australian dollar terms) and a very large driver of our stock market rally since the global financial crisis – and more recently the Euro-crisis days of 2012 – but have struggled in the past year. Prior to 2015, with the combination of interest rates at all-time lows and growth around long-term trend levels, the banks were able to grow their mortgage books at the same time as problem loans dissipated. This led to a sustained, steady rise in stock prices, bank profits and dividends. The issue now is that many parts of the economy are carrying too much debt, cyclical sectors like energy and mining are turning down and bad and doubtful debts (BDD) are starting to pick up, albeit from very low levels.
In recent months an uninspiring housing backdrop continued to pressure top line growth via volumes, with further pressure on margins from the RBA’s recent interest rate cut and wholesale funding cost volatility. With credit growth expected to remain subdued, top line growth pressures will continue to weigh on earnings and affect margins as the majors compete for market share. Investor/buy-to-let housing lending has been in decline (as intended) since the introduction of the Australian Prudential Regulation Authority’s (APRA’s) measures to curb investor-fuelled residential property price growth, particularly in major cities. This has been partially offset by increased owner-occupier lending and faster business credit growth. This comes alongside a push to get banks to raise their tier one capital levels which essentially means that banks will hold more capital against their balance sheet which, in Australia, predominately comprises of residential mortgages. These regulatory actions drove banks to step up capital raising activities last year. Even though the big four banks raised a combined A$19.5 billion of new equity since May 2015, we may see more raisings over the coming months. Commonwealth Bank analysts are predicting over A$32 billion being raised by the banks over the coming year to meet APRA’s higher capitalisation standards. The increased capital requirements will weigh on the profitability of these franchises but will improve their quality by reducing their leverage at, what feels like, a heated point in the property cycle. Ultimately, the major banks should reprice for the higher capital requirements and lower returns on equity, but they will increase their safety.
Bad and doubtful debts likely to pick up from here
With impairment charges (as a percentage of gross loans) bottoming, asset quality appears to have peaked in 2015. The bottom of the bad debts cycle has been prolonged by stable unemployment and low interest rates which have boosted asset valuations and improved serviceability. From here, given the economic and housing headwinds, it seems a normalisation of bad debts is coming. The question is how quickly could bad debts rise and where will they peak. With pockets of stress in specific industries or regions beginning to surface we expect this to be a feature of coming results. Whilst households make up the vast majority of major bank lending, housing credit conditions are supportive and will remain so for some time – serviceability is high, prepayments are high and dynamic loan-to-value ratios are low at approximately 47%. Additionally, mortgage loans have historically remained resilient during recessionary periods – the bad debts of the 1990s were driven mainly via business lending, while households largely continued to service their debt. However, much of the asset quality deterioration we saw in the results this quarter – ANZ and Westpac almost doubled impairment charges in the last six months, while the Commonwealth Bank raised them 67% – was driven by loans related to specific industries and geographies that continue to face pressure. As Australia moves past the mining boom phase much of these impairments have been realised by resource-related exposures like Arrium and in the bank’s Western Australia’s residential mortgage portfolio. Likewise, impairments have been seen in the institutional book with large loans made to companies under stress such as Slater & Gordon and Dick Smith, as well as dairy producers exposed to the ongoing dairy price weakness. But a larger driver of sentiment will be what happens in the East Coast mortgage lending books where metropolitan areas have very stretched property valuations relative to incomes.
Marginal property buyers taken out: credit being withdrawn from investors and foreign buyers
Another development that impacts property prices and bank revenues has been the stepping up of APRA’s oversight of the mortgage market, particularly by limiting loan growth to 10% per annum in the buy-to-let segment. With the steep run up in property prices, particularly in the large metropolitan centres of Melbourne and Sydney, the regulator is trying to curb over-speculation in a hot market with fast declining interest rates. This is a better outcome than the inflexible macro-prudential moves we’ve seen in some overseas markets where higher minimum deposits, of around 20%, have been implemented. APRA’s approach allows domestic banks to decide who is creditworthy and who is not. It also limits the amount of credit injected, into what can be a volatile part of the market, if property prices falter. Banks are now also constraining capital to offshore investors, who have been the marginal buyer of many properties in the past few years. This could have a disproportionate impact on property developers who may find themselves with customers who have perhaps bought properties off the plan but may struggle to get finance upon completion.
Fundamentals: earnings growth moderating, but banks are still very profitable
The big four banks have very strong fundamentals right now. However, it’s not where they are now but where these fundamentals are going that will help determine each bank’s share price. The banks have increased home loans and improved asset quality since the start of the rate-cut cycle in November 2011. Margin pressure has stabilised as cheaper wholesale funding helps offset declining asset yields, along with the benefits of cost and bad and doubtful debts. While the banks' dividend streams may appeal to investors, they may face downward pressure from tier one capital requirements. With the RBA interest rate cuts continuing to buoy the banking environment, it will be important to keep an eye on where asset quality can move from here.
Valuation: now more reasonable but dividends may be trimmed
Valuations are now moving to reflect a lower growth profile for earnings and dividends but our banks still sit on high price/book valuations (P/B) relative to comparable global peers. Australia's big four banks yield an average 6.0% in dividends (unfranked). The banks will continue to provide strong dividend streams, but these dividend levels may prove difficult to sustain in the short term due to high payout ratios. Finally, the banking sector’s P/E is the lowest in the ASX 200, albeit these are based off near record earnings measures which may dip.
Sentiment: increased regulation and slower profit growth are reducing the hype
The sharp falls in early 2016 and subsequent rally suggests they will face volatile trade as the domestic outlook changes. Volatility has brought some of this enthusiasm on the sector into check, but this is not necessarily a bad thing. There is a risk that the rebalancing of the economy away from the mining sector falters, the market takes a leg down and sentiment on the banks comes under pressure as earnings decline scenarios are discounted.
Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.