Australian Banks: The Outlook For 2014

This story features COMMONWEALTH BANK OF AUSTRALIA, and other companies. For more info SHARE ANALYSIS: CBA

– Bank PE expansion significant
– Earnings growth remains subdued
– Dividends remain attractive
– Various headwinds to consider

By Greg Peel

Commonwealth Bank ((CBA)) will report its half-year result mid-February and each of ANZ Bank ((ANZ)), National Bank ((NAB)) and Westpac ((WBC)) will provide December quarter updates during the month. This will provide the first indication as to how the banks are faring as we move into 2014 and the Australian economy attempts to transition from a mining to a non-mining focus.

Of the past three years of major bank share price appreciation, notes BA-Merrill Lynch, 73% can be attributed to “PE multiple expansion”. On FY14 forecasts and current share prices, the Big Four are averaging a price/earnings ratio (PE) of 13.6x, with CBA the stand-out at 15.2x. What Merrills’ calculations imply is that only 27% of the three-year rise in share prices can be attributed to increased earnings – that which, at the end of the day, drives stock value – while 73% can be attributed to the market simply paying higher and higher share prices for that same earnings growth.

Under normal circumstances, a stock’s PE will rise in anticipation of future earnings growth, but for the best part of the last three years, the subdued credit growth environment in Australia has meant equally subdued forecast earnings growth. In recent months we’ve seen a pick-up in housing investment in Australia, leading to improved expectations for housing credit growth, but credit growth in other sectors, particularly business, continues to languish. In the case of the banks, something else has been driving PE multiple expansion.

And of course we know the answer to that is “yield”. As long as the banks can maintain attractive dividend yields, investors all over the world will find Australian bank yields attractive. The lower interest rates fall domestically and offshore, the greater that attraction will be. And the banks have had another trick up their sleeves.

Starved of meaningful credit growth in recent years, the banks have still managed to book significant “earnings” by reducing bad debt provisions. All this means is a lot of the money the banks put aside after the GFC as a buffer against a run of bad loans (back when we all thought the world might end) has been brought back to the P&L as “earnings” (given the world didn’t end). These “earnings” windfalls bolstered balance sheets and allowed the banks to pay back shareholders who suffered when everything was going the other way in 2009-10. The banks increased their dividend payout ratios (of earnings) and offered up special dividends, thus increasing their yields, thus increasing their attractiveness, thus increasing share prices, and thus increasing their PE multiples.

So here we are. Now what?

Let’s first consider the following one-year chart.
 

 

The blue line is the ASX 200 (XJO) and the red line is the ASX Financials ex-REITs (XXJ). We can clearly see the big “sell in May” correction of 2013, which was driven by the first hints of Fed tapering, and the point at which bank yields began to act as a parachute. When sentiment turned in June, the banks led the charge. The rest of the market caught up around September (bear in mind the banks represent a significant chunk of the index and hence there should be correlation) but when tapering appeared to be truly on the cards, the banks again provided a yield parachute in December. Again we bounced, and again the market caught up. But as we entered 2014…

Let’s zoom in now to a three-month chart, and we see that the relationship has reversed.

 

 

The banks have underperformed the index, and we can largely put that down to two factors. Firstly, as global economic growth forecasts improve, investors have been switching into resource sector exposure. Secondly, the banks have reached levels which, on PE multiples, investors feel leave little room for further upside. Hence it is the banks out of which investors have switched.

On Merrills’ numbers (comparing current to long-run average PE multiples), NAB is 10% overvalued, ANZ 12%, Westpac 13% and CBA 19%.

Outside of housing, credit growth is forecast to remain subdued in 2014, and hence bank earnings growth is expected to remain at single-digit percentage levels. Significantly, bad debts are now close to record lows. Not post-GFC lows, but record lows. In other words, the windfall days of redistributing bad debt provisions to shareholders are possibly coming to an end (perhaps with the exception of NAB’s UK exposures).

That said, Macquarie believes there is still the potential for lower impairments in 2014 when comparing to the past twenty years given the next ten years will feature a much lower prevailing interest rate environment. The broker has subsequently lowered its bank impairment forecasts for the period, suggesting the potential for further provision releases.

There is little agreement amongst analysts. Goldman Sachs believes the second half of 2013 will show to have marked the trough in bad debt reductions, with the uncertain domestic economic outlook leading to a potential increase from here.

Nevertheless, forecasts for global economic growth in 2014 have been improving. The IMF, for example, is forecasting 3.6% global GDP growth in 2014 compared to 2.9% in 2013. Over the past ten years, the Big Four have underperformed the index when global growth has accelerated and outperformed when growth has slowed, Merrills has found. This is simply a relative measure – resource sector stocks perform much better in times of global growth. Over 25 years, this relationship remains 80% accurate.

And over the past twenty years, Big Four earnings growth has averaged twice the current forecast growth rate for FY14-16 of 5-6%. Merrills doesn’t see much in the way of earnings downside risk for the banks, but it doesn’t see a lot of upside either against a backdrop of low bad debt levels and stretched PE multiples.

The economy is one thing, but outside of post-GFC economic trends the banks also have to deal with GFC-inspired global regulatory changes. Fundamentally, banks across the world now have to hold a higher ratio on their balance sheets of common equity tier one (CET1) capital, which in Australian terms means ordinary shares. Before the GFC, the Big Four averaged 5.5% of CET1, notes JP Morgan. Today that average is pushing above 8%.

The Big Four are also categorised amongst world banks as “D-SIBs”, or “domestic systemically important banks”. Or in simple GFC parlance, “too big to fail” in a domestic sense. The Bank of International Settlements (BIS) recently decided D-SIBs need an extra 1% of CET1 on their balance sheets as a precaution.

Then there are net stable funding ratio (NSFR) requirements and liquidity coverage ratio (LCR) requirements. The latter refers to the level of liquid assets held on balance sheets that can be readily cashed in in times of crisis to head off another liquidity crunch, and to that end they must also thus be “risk free” assets, basically meaning government bonds. The RBA was forced to step in with regard to LCRs and gain approval from BIS to provide a committed liquidity facility for Australian banks given the Australian government simply does not issue enough paper for the banks to buy, despite political hysteria over government debt.

Australian banks have been building up their capital positions since the GFC, initially by cutting dividends and directly raising fresh capital and then by “back-door” capital raisings through dividend reinvestment plans (DRP), as well as reducing liabilities. Assuming the Australian Prudential Regulation Authority (APRA) applies the new BIS rules as they are, and not strengthen them, then the Big Four are looking pretty comfortable as far as JP Morgan is concerned. The banks themselves have clearly been feeling more comfortable, as they have recently both increased dividends and “neutralised” DRPs (meaning no fresh capital issued). The rules will come into force in 2016 and by that stage the banks will have increased their CET1 ratios further.

This means ratios of around 9% will be required, suggests CIMB, if the banks are to maintain current dividend payouts (which reduce CET1 by 1%). There should be no trouble in reaching 9% while loan growth remains subdued. However, the additional D-SIB requirement will act as a drag on banks’ return on equity, and hence even a modest rebound in business lending growth is likely to mean an end to the neutralisation of DRPs, CIMB suggests, implying shareholder dilution.

In other words, while Australian banks are in a more comfortable capital position than most banks around the world, a recovery in credit growth which, of course, is what we’d all like to see, will actually be encumbered in bank valuation terms by the new post-GFC regulations.

Another consideration for the Big Four as the GFC fades further and further into the distance is that of competition. After a long hiatus, non-bank lenders are now returning to the game.

Mortgage broker AFG has for the first time published data outlining bank and non-bank loan originations by product and brand. The November data, suggests JP Morgan, confirm non-bank lenders are now back to capturing a greater share of new home loans, at 23% of all AFG originations. Banks have recently started to increase broker commission rates once more, supporting broker-led originations. They now stand at an all-time high of around 45%.

Fixed rate mortgages have become very popular in the new low interest rate environment, and the share of new fixed rate mortgages for non-banks has increased to 40% from 20% only one year ago. On the other side, banks’ share of new fixed rate mortgages has decreased to 60% from 80%. Nonetheless, banks still control around 80% of all existing mortgages.

But they are not satisfied. Competition amongst the majors for new mortgages is heating up once more, with discounted floating rates being offered on the one hand and increased loan-to-value ratios (LVR) on the other. Banks profit more from larger sized loans, so the greatest discount and LVR concessions are being granted on the larger loans.

It looks like, at least from the banks’ perspective, the GFC is dead and buried. How far back can we go into lax lending practices?

On the other side of the balance sheet, however, competition for deposits amongst the majors is easing. Term deposit spreads hit their lows one year ago and are now an average 60 basis points higher, Goldman Sachs notes. This eases the margin pressure associated with mortgage loan competition.

None of the above paints a particularly clear picture of whether the Big Four can carry 2013 share price momentum into 2014. Merrills cites overblown PE expansion on the one hand, while CIMB’s view is not as bearish. Sure, says CIMB, the banks are overvalued on both price to earnings and price to book value bases, but only marginally, relative to the wider market. Assuming no near term threat to earnings and dividends, the banks remain attractive compared to other industrials and resource stocks, the broker suggests.

In assessing the Big Four, let’s look at where they stood back in November, shortly after the full-year reporting season.
 

 

Despite overvaluation calls, the table above shows only CBA was at the time trading at a share price above its consensus target price. Following solid earnings reports, driven largely by bad debt provision returns, analysts collectively raised their targets. In so doing, they satisfied the long-run FNArena observation that when bank share prices exceed target prices those share prices are set to fall, unless analysts find reason to raise their target prices.

We also note ANZ was the most preferred bank on consensus, attracting four Buy ratings, while the perennially “overvalued” CBA sat in last place with only two Buy ratings.

Moving ahead to today, based on yesterday’s closing prices, we find that if this consensus table is any guide, only CBA is strictly overvalued, as it was in November, and the upside to target prices in general has increased. There have only been slight changes to target prices in the interim. Clearly these numbers are impacted by recent falls in bank share prices, as noted in the chart above.
 

 

We also see ANZ has lost top place to NAB, albeit both attract only three Buy ratings, while CBA has slipped further at last place with only one Buy rating.

The pullback in share prices has also naturally affected an increase in dividend yields, which are, on a fully franked basis, still attractive. On that basis, it is hard to see bank share prices falling significantly over 2014, barring any left field disaster. But parachutes aside, it will be tough for the banks to provide further PE expansion until earnings growth can improve beyond the “subdued”.

If the global economy performs well in 2014, and forecasts have the “world” performing better than Australia, then resource sector stocks will draw more attention and the switch will continue, undermining bank share prices. Furthermore, if the Fed keeps tapering on US economic health, the next step is for higher US interest rates. Once this occurs, incremental increases will chip away at the offshore attractiveness of Australian bank shares, and a falling Australian dollar will also act as a deterrent to Australian investment in general.

Perhaps 2014 will be the year the banks return to simply being “defensive” stocks, as they once used to be.
 

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