Trying To Make Sense Out Of The Non-Sense

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

This story was first published two days ago in the form of an email sent to registered FNArena readers.

By Rudi Filapek-Vandyck, Editor FNArena

At least one of Australia’s banks is in serious trouble. According to the local rumour mill, that is. FNArena first heard about the rumour in late January. At the time, it made sense to link it to Commonwealth Bank ((CBA)) as the bank was about to release its interim results in mid-February and securities analysts had started to anticipate it would likely prove to be a disappointing exercise. It turned out, this was correct and CommBank’s increased provisions and downward pressure on margins both came out above expectations. Thus started the non-discriminatory second leg sell-down for Australian banking shares.

But the rumour persisted and soon ANZ Bank ((ANZ)) would follow with a public admission it had direct exposure to a troubled monoline insurer in the US. FNArena had already concluded the rumour probably originated from overseas, so this link made even more sense. Obviously, someone down there had picked it up and discovered the link to ANZ?

Alas the rumour hasn’t gone away and this week it returned with a vengeance, apparently creating a widening gap between 90 day bank bills and Australian government bonds. Word on the street is foreign bond holders are shying away from exposure to Australian banks, preferring the safety of government backed debt instead.

On the other hand, the rumour mill this week also brought the return of supposed corporate interest for Queensland bank-insurer Suncorp-Metway ((SUN)).

This is what some market observers would refer to as “an old hat”, though part of the investor community is likely to take the view that as Suncorp shares are not that far from having fallen 50% off their peak from early October last year, it would seem but logical someone somewhere has started to look into the opportunity at hand.

It is my suspicion that the resurgence of the Suncorp take-over rumour contributed to the overall recovery of banking shares on Tuesday which occurred against the overall market trend on the day. No doubt, rumoured corporate interest for Suncorp confirmed what most supporters of the sector have been saying since February: banking stocks are looking cheap (and cheaper by the day).

Whatever the validity of both rumours -and we will ultimately find out whether there’s any substance to them- the future of the Australian share market, and of the Australian economy, now more than ever lies with the banks.

Let’s go straight to the core: the global financial system is no longer functioning properly. No surprise there. We’ve all read enough stories about lenders calling in margin loans, banks having to pay up for wholesale funding and independent mortgage lenders being squeezed out of the Australian market (not to mention subprime related write-downs and forced capital raisings elsewhere).

However, what has thus far barely received any mentioning in the media, or elsewhere, is the amount of forced selling in the markets. Part of this is because nobody has any idea (those who are selling are trying not to attract any attention). It is my suspicion there’s much more “distressed selling” going on than most of us would assume at prima facie. And there’s likely much more to come still.

To put it simple: if bank shares fall by 4% on any given day, does this imply that resources stocks have to weaken by 2% on the same day? And what if commodity prices have risen by a few percentages overnight? What if leading stockbrokerages have started to lift their price forecasts for oil, metals and minerals prices?

Share prices of resources companies have lagged the strong price movements for most of their products over the past few months. Over the past few weeks, however, the already weakened relationship has looked at times completely absent. Similarly, while large resources stocks such as BHP Billiton ((BHP)) and Rio Tinto ((RIO)) were dragged lower over the past week together with financials, property trusts, utilities and most other sectors in the Australian share market, small cap resources have continued to outperform.

The small resources index put in a slightly positive performance last week (up 0.8%) amidst the carnage that was felt across the board elsewhere. However, the strong differences in performances between small cap miners and energy companies show this is not a sector suited for all types of investors. Last week, the shares of Riversdale Mining, Albidon Mining and Sino Gold Mining all gained between 12-18% while those on the other side of the coin including Perilya ((PEM)), Petsec Energy and Tap Oil ((TAP)) lost 19.5% or more.

The strong outperformance of small cap resources stocks, I believe, can partly be explained by the absence of “forced sellers”. Banks and other financial institutions across the globe are rewinding the liquidity they have helped create throughout the past years. This is not a coordinated attempt to destabilise financial markets or the global economy, but a natural reflex as their balance sheets have been shot to pieces and they remain under threat. This affects all types of customers, good and bad.

Anecdotal evidence suggests there are wars for survival being fought behind the curtains of today’s financial markets with many distressed investors trying to avoid having to sell in a weak market. This in itself leads me to the conclusion that this process is far from over. It is more likely we have only seen the early stages of it.

Australian banks have yet to join their peers in the US and Europe in this process, but early signs are we can expect a similar response. Already staff meetings are taking place at the banks to discuss the changing environment in Australia, more in particular; the increase in corporate defaults and the anticipated increased financial stress upon Australian households. The biggest fear for Australian companies (and therefore also for investors) is that if Australian banks will start rationing their loans, this will limit Australian businesses in their access to funding and thus in their future growth.

Now that the corporate bond market has frozen, and share prices have taken a substantial fall, banking loans seem but the only option left for Australian businesses. The irony is, however, that these banks are victims themselves of the frozen global credit markets, hence the likelihood they will either have to start raising fresh capital, or rationing their loans, or both.

While all this does not necessarily has to end in the worst manner possible, it does suggest that current problems in the global financial system appear nowhere near a swift solution.

Unfortunately, global equity markets are very much part of the global financial system. It may well be that share prices for the likes of BHP Billiton and Rio Tinto won’t be able to reach their full potential unless the problems in the banking sector have been largely solved.

That might still take a while.

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