Banks adjust to new operating environment
For many SMSF investors, local banks form an important part of their investment portfolio. While banks have delivered strong performance and good dividends in the past, many of the variables that impact their earnings have changed in recent years.
This is the second in a two-part series on the different influences on banks’ profitability investors should be taking into account. The first article explored earnings drivers as well as a potential increase in bad and doubtful debts. Here, we look at regulatory impacts on bank performance.
Credit withdrawn from investors and foreign buyers
An important development that has impacted property prices and bank revenues has been the stepping up of the Australian Prudential Regulation Authority’s (APRA’s) oversight of the mortgage market, particularly by limiting loan growth to 10 per cent 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 in some overseas markets where higher minimum deposits of around 20 per cent 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 bought properties off the plan but may struggle to get finance on completion.
Earnings growth moderating, but banks still profitable
The big four banks have very strong fundamentals. But 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: more reasonable, but dividends may be trimmed
Valuations are now moving to reflect a lower growth profile for earnings and dividends but banks still sit on high price/book valuations (P/B) relative to comparable global peers. The big four banks yield an average six per cent 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. The banking sector’s P/E is the lowest in the ASX 200, albeit these are based on near record earnings measures, which may dip.
The sharp share market falls in early 2016 and subsequent rally suggest banks 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 the rebalancing of the economy away from the mining sector will falter, and sentiment on banks comes under pressure as earnings scenarios are discounted.
Earnings delivery is likely to become more important. With recent profit results pointing to low rather than high single-digit growth in profit earnings, any hint results may come in flat or lower will likely push share prices lower.
We expect valuations will moderate, but there will still be yield support. Near term share price movements are likely to reflect tension between capital concerns on the one hand and yield support on the other.
But don't reach too hard for yield. After six years of ultra-low interest rates, many of the assets traditionally used to obtain yield have been bid up due to demand from investors seeking yield. Don't target high yields at this stage of the cycle as you may well find yourself risking capital to get that higher yield. Don’t just look at headline yields; think about how sustainable that yield and the earnings of that business is over time.