On Chinese Tightening And Australian Banks

This story features NATIONAL AUSTRALIA BANK LIMITED. For more info SHARE ANALYSIS: NAB

By Greg Peel

For the world, and the Australian market in particular, China's moves to tighten monetary policy and slow its economy had precipitated earlier nervousness, but now the European crisis has hit a crescendo any further potential tightening has markets running scared.

Early in 2010 global stock markets wobbled on a combination of Greece and a declaration by Beijing that it wanted to rein in Chinese economic growth from 12% to 8% to prevent a more severe later bust. But the Greek threat was soon dismissed as immaterial by many and if Chinese tightening was only intended to reduce GDP growth from “bubbling” to simply “strong” then where was the overall harm in that?

Hence we hit new highs in April. But not only did the European crisis escalate thereafter but it also became clear Beijing specifically wanted to smash the Chinese property market to shake out destructive speculators. As housing accounts for a significant portion of Chinese commodity demand, this was not what Australian investors wanted to hear.

For Australia's two biggest sectors – resources and banks – the news has simply been all bad lately. For resources its been Europe, Chinese slowing and the RSPT and for banks its been Europe, local growth headwinds and US financial sector reform. Stocks have moved from largely overbought to potentially oversold. They are definitely oversold on a valuation comparison, but the immediate outlook still depends on more certainty regarding the European rescue packages.

And it depends on China. But analysts agree that there's little chance Beijing will now step up its tightening plans, and for that matter currency revaluation intentions, while European instability remains. Indeed, China experts note Beijing is prone to making sudden policy turnarounds if the situation requires. It might even ease policy again, some suggest. And that would be good news in Australian markets.

Citi's economists don't believe Beijing will actually cut interest rates having recently raised them more than once, but they do believe the Chinese authorities will back off from their earlier aggression. Citi previously believed Beijing would hike rates three more times in 2010 and five times in 2011, but now they forecast two more hikes in 2010 and three in 2011. They still suggest another hike is on the cards in the September quarter.

Now that commodity prices have weakened, Citi sees a lagged peak in Chinese consumer and producer price inflation in the September quarter. Inflation is Beijing's biggest fear both in asset prices (property in particular) and the CPI given the experience of the first half of 2008, when Chinese inflation ran rampant. Thereafter however, inflation should again resume an upward climb and once markets settle down remain above 4% in coming years, says Citi.

Any signs that Beijing is prepared to slow up on its intended slowing, at least while Europe tries to sort itself out, is good news for Australian commodity producers. The problem is, however, Beijing may not make an announcement about doing nothing and so uncertainty could still hang around.

In the meantime, it is fairly clear that if Australia does get an RSPT, and obviously this year's election is an important factor here, it will have been watered down to some extent first. Hence the worst case tax scenario is already built in to resource sector prices as they wallow in global fears.

What is also very likely to be watered down from their current levels are the measures contained in the US financial reform bill. Again, leaving aside European debt woes, the worst case scenario is likely built into US financial sector prices.

But aside from this indirect influence on Australian banks, BA Merrill Lynch suggests fears of the impact of global funding issues on Australian banks look “well progressed” now. And those earnings headwinds suggested at the top of the market are long ago factored in. The Merrills analysts believe its difficult to see local banks reaching trough valuations again and valuation support should start to kick in.

The Merrills equity strategists are nevertheless remaining cautious on the general stock market, so the analysts suggest “probably the best case for banks is to recover in an otherwise troubled market” given the banks have fallen around 15% since April – about 4% more than the market.

In choosing among them, Merrills suggests National Bank ((NAB)) is the best way to play the sector in the current environment.

NAB was already at a discount to its Big Four peers, and those earnings headwinds and potential local regulatory tightening are going to impact on the other three more, says Merrills. All up, Merrills has a Neutral sector rating, noting the banks could return to their more traditional role of “low growth defensives” as these global problems play out in a market where recovery favours stocks not directly exposed to Chinese slowing.

The sector's underlying PE multiple is currently 6.3x if you don't count bad debt provisions being returned to the bottom line, Merrills calculates, against a long-run average of 7.3x. So they are on the cheap side, but Merrills does not expect they'll actually become expensive again anytime soon.

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