Brokers Still Like The Banks

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– Analysts now expect weaker credit growth
– Yet earnings impact not as significant
– Yields are strong and banks are defensive 

By Greg Peel

At FNArena's last update on the Big Four banks at the end of June, the current market correction (now worth about 13%) was only warming up. It began with renewed problems for Greece before spreading to Spain and Italy, and on to the US. In the interim, not only has the US economic recovery stalled but Australia posted a negative GDP and is suffering a severe consumer downturn.

At the end of June, bank analysts were unconcerned about the impact of a resurfacing eurozone debt crisis on the fortunes of Australian banks. While there was some risk of increased offshore funding costs as a result of higher global risk premiums, credit growth remained subdued in Australia. This allowed for a somewhat ironic twist that if the banks didn't have to borrow much more to fund low credit growth, then the impact of higher interest costs would be less.

Bank analysts have long expected an eventual recovery in business credit demand in Australia, although they have been forced into continually pushing out their expectations along the time curve. At end-June bank analysts were not exactly forecasting strong earnings growth for the banks, they just didn't see the need for the sell-off. Hence if we review the table below from that time, we see significant upside in each bank to its consensus target price.

At its July policy meeting, the RBA described credit growth as “modest”. At its August meeting yesterday, the RBA suggested credit growth is now “very subdued by historical standards”. At end-June economist consensus was for a rate rise in August. Today, well, economists have no idea what the hell's going to happen.

Bank analysts nevertheless agree with the central bank's assertion that credit demand has weakened. Today two brokers – Goldman Sachs and RBS Australia – have said as much in respective reports.

Goldmans is now expecting “significantly” lower credit growth than previously assumed, forecasting a recovery of only 7-8% per annum over the next three years. That's half the growth rate of the five years leading up to the GFC. Nor can the analysts rule out further deterioration given the current cautious Australian household.

RBS still expects a more positive outlook for business credit growth ahead, but has now pushed out the expected timing of any improvement. It is notable that the RBS analysts were once skeptical of consensus rebound expectations and had long ago assumed a slower recovery, but now even they are shifting out into time.

In both cases, the analysts do not expect the impact on bank earnings to be proportionately equivalent.

Remembering that a bank effectively makes its money on the simple difference between its borrowing and lending rates, the irony is that earnings risk is reduced if they don't do much lending. Margins are more stable, bad debt risks lower, costs of doing business are lower, and capital requirements are more stable. There is therefore more potential risk of volatility of bank earnings in a boom-bust period (let's say 2004-09) than there is in a “chugging along in a quiet market” period (let's say 2010-??). Add that all up and Goldmans suggests that significantly lower credit growth should only lead to a subsequent 1-3% reduction in bank earnings.

RBA takes a different tack, comparing economists' consensus expectations for both credit growth and the labour market. The former we know are weak, but that latter remain strong. Given the resource sector employs less than 2% of the Australian workforce, RBS suggests there is a disconnect at work.

Taking labour market expectations, RBS suggests these imply business credit growth of 7-9%. Given exogenous (offshore) events are impacting on business confidence and thus the timing of a credit growth recovery, RBS has downgraded its bank earnings forecasts by 2-3%.

[RBS makes no suggestion that it is consensus labour market expectation that is unbalanced against credit growth expectation, meaning the analysts are not seeing a sudden jump in unemployment perhaps through retail sector lay-offs, for example, which is not beyond the realms one would assume.]

While this FNArena bank update draws specifically on only two broker reports, other brokers have been conspiratorial in their silence. Because when we compare the same table as above now updated to yesterday's closing prices, we note two things. One is that consensus target prices have ticked down only marginally, and the other is that the number of Buy ratings on the Big Four from the eight brokers in the FNArena database has increased from 14 to 17.

The target price adjustments have meant that those same upside-to-target percentages so significant in June remain stable in August – 10% for the Commonwealth ((CBA)) and around 20% for Westpac ((WBC)), ANZ ((ANZ)) and National ((NAB)). But this time I have also added a dividend yield figure.

The reason why I have should be obvious – those yields look pretty significant, particularly when one adds on the gross-up for 100% franking (not included in the table). Note that these are FY12 consensus forecast yields, meaning July 2011-June 2012 for CBA and October 2011-September 2012 for the other three.

What are the risks in investing in the Big Four banks today? Well, as we watch the market tanking the obvious answer is “share price downside”. Sentiment aside, downside risk can come from increased borrowing costs, increased bad debts, lower earnings and reduced payouts. But an interesting change has occurred.

In 2007-08, the bulk of Australia's bank analysts made a glaring mistake in assuming that because bank stocks were historically considered “defensive”, they thus would be a port in the storm of the credit crisis. The problem is that Australia's banks had switched from being defensive in the twentieth century to very cyclical in the noughties boom – so much so that they were always going to cycle down with all the other cyclicals in the bust. It took a while for bank analysts to figure this one out.

Today, analysts are suggesting that low credit growth will not impact too much on bank earnings. In other words, by any definition, Australia's banks are once again “defensive”. And those yields provide a buffer against further downside. All that is needed is for the market to adjust to this new (yet old) view as well.
 

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