Banking juggernaut stalling: questions remain on dividends and asset quality
Some of the factors that are likely to impact bank stock valuations in the near term.
Across the board, banks are dealing with slower profit growth and lower asset quality, driven by the poor performance of customers that are resources-related business and by institutional lending. With the market slowly realising the period of record profits and high dividends is coming to an end, valuations of the Commonwealth Bank, Westpac, National Australia Bank and ANZ have begun to drop in recent months.
Offsetting this is the Reserve Bank of Australia’s (RBA) recent cut to the cash rate to a record low of 1.75 per cent, which 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, pressure on the sector will continue and investors need to acknowledge the changed environment and review their positions. The banks represent a large proportion of retail direct equity holdings, so SMSF investors need to be prudent about the extent of their holdings and consider taking profits by trimming back oversized positions.
Profit drivers beginning to fade
The banks have been top global performers and a large driver of Australia’s stock market rally since the global financial crisis, but they have struggled in the past year. Thanks to a combination of interest rates at all-time lows and economic growth at around long-term trend levels, 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 are starting to pick up, albeit from low levels.
In recent months an uninspiring housing backdrop has pressured top line growth, with further pressure on margins from the RBA’s recent interest rate cut and wholesale funding cost volatility. As credit growth is 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 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 raise tier one capital levels, which means banks now hold more capital against their balance sheet. Banks have raised $19.5 billion in new equity since May 2015 and there may be more raisings over the coming months. Increased capital requirements will weigh on the profitability of these franchises but will reduce leverage at what feels like a heated point in the property cycle.
Bad and doubtful debts: what’s the likely increase?
Asset quality appears to have peaked in 2015, with impairment charges as a percentage of gross loans bottoming. 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. It seems a normalisation of bad debts is coming, given the economic and housing headwinds. 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 in coming results.
While households make up the vast majority of major bank lending, housing credit conditions are supportive and will remain so for some time. This is because serviceability is high, prepayments are high and dynamic loan-to-value ratios are low at approximately 47 per cent. 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 seen recently 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. 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 east-coast mortgage lending books where metropolitan areas have very stretched property valuations relative to incomes.
It will be interesting to see how this plays out over the course of the year.
About the author
Dermot Ryan manages concentrated portfolios of Australian equities for AMP’s retail investor base. Mr Ryan joined AMP in 2014 from Commonwealth Private, where he managed their direct Australian equities model and SMA portfolios. In addition to equities portfolio management, he also ran a dynamic asset allocation program and client engagement through regular newsletters and national seminars. Prior to this he worked for Colonial First State Global Asset Management in both their London and Sydney offices as an Investment Analyst across global equities in a number of sectors as well as a period in their global fixed income team.