Australian Banks: Not So Overstretched

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– Banks no longer way overvalued
– Yield support on offer
– Credit outllook subdued
– Earnings growth outlook minimal
 

By Greg Peel

While weak data and credit squeeze ramifications in China have provided one driver for the Australian stock market’s correction from the May highs, speculation and then confirmation that the US Federal Reserve is considering just when it might begin to ease back on its bond purchases and slow down QE have effectively burst Australia’s manic yield bubble. Local investors have been eager to put their money in bank, telco and other high-yield shares as the RBA cash rate, and thus bank term deposit rates, have fallen.

But investors from the rest of the world, particularly in the US and Japan, had been the most influential driving force behind Australia’s yield rally, given  as good as zero interest rates at home. The sharpness of the subsequent pullback lends itself not only to increases in both US and Japanese government bond yields, but also to concurrent weakness in the Aussie dollar, threatening a double-whammy of losses for offshore investors.

Australia’s banks are very popular offshore, having come through the GFC relatively unscathed, being backed by deposit guarantees from a AAA-rated government, and providing world-leading dividend payout ratios at a time major global banks are still paying back government bail-out funds. But the allure dissipates when yields start to rise at home.

May saw the big sell-off in banks, while June provided volatile consolidation as the resources sector copped the brunt on China fears. The banks out-peaked the index in May, fell similarly but pulled up faster on yield support. Domestic investors remain attracted to fully-franked bank dividends at the right level even if offshore investors are happy to get out. The major banks rose an average 2.8% in June to the ASX 200’s 2.5% fall.

For the year ended June, the ASX 200 rose 17.1%, significantly outperformed by the major banks over the period. Westpac ((WBC)) recorded a 37.1% rise, Commonwealth Bank ((CBA)) 30.3%, ANZ Bank ((ANZ)) 29.7% and National Bank ((NAB)) 26.1%. We do not see such numbers very often. And they include the pullback in May. Below is a chart of the ASX financials ex-REITs index (XXJ).
 

 

Strength in bank shares prices over the year was all about dividends and had little to do with actual earnings. Australia’s subdued credit market has ensured minimal earnings growth from traditional banking, rather growth has been provided from the return of bad debt provisions, as GFC tail risk rolls off, and from beneficial mortgage repricing (not cutting SVRs by as much as RBA cuts).

Subdued demand has nevertheless led brokers back to competitive mortgage pricing but on the flipside deposit bases are now stronger and offshore funding costs fell over the period. Capital ratios are now the envy of the world and provision returns have allowed the banks to pander to a yield-hungry market with increased payout ratios and special dividends. The market pullback has returned share prices to a level at which yields are once again attractive. But whereto from here?
 

The above table suggests that across the eight leading brokers in the FNArena database, the Big Four banks attract a total of 13 Buy or equivalent ratings, 14 Hold and 5 Sell. The only notable change from the last FNArena bank update in May is that ANZ has gained two more Buys, from previous Holds. Despite brokers almost universally agreeing that peak price levels overvalued the banks, analysts were reluctant to stand in front of the locomotive of yield demand. It took Fed speculation to deflate the bubble, and at lower price levels analysts can now feel a little more comfort about their recommendations.

That comfort is reflected in the fact share prices exceeded consensus target prices at the peak but now targets exceed prices, with the exception of CBA. The level of upside to targets largely determines the consensus order of preference with the exception of Westpac, which exhibits both the lowest FY14 earnings growth forecast and the lowest dividend growth forecast, having delivered its dividend goodies in FY13.

Note that only CBA reports on a June-end financial year, with the other three reporting on a September-end financial year.

Yields have also now improved to an average of around 6% before franking. Given the banks pay dividends based on a ratio of earnings, the actual quantum of dividend paid will still be determined by earnings achieved unlike, say, Telstra, which offers fixed quantum dividends. Thus the earnings growth outlook remains important for bank investors.

APRA's latest credit data, for May, provide some clues as to earnings growth potential going forward. System credit grew 0.3% in May for 3.0% annualised growth, the weakest point in almost two years, BA-Merrill Lynch notes. Macquarie was at least prepared to suggest “some green shoots sprouted in May”.

Lending for housing, which represents around 60% of system credit, was up 0.4% for the month and 4.5% year on year, with CIMB noting the same 0.4% and 4.5% combination was recorded in April. Business lending, at 34% of system, rose 0.1% in the month and 0.9% year on year, compared to 0.2% and 1.4% in April. Personal lending, at 6% of system, maintained its weak performance by falling 0.1% in May and 0.2% year on year. The numbers might suggest that while personal lending, which includes credit cards, remains firmly in the doldrums, and business lending is still struggling to grow, housing lending looks okay. But CIMB notes the annual housing growth rate is the lowest since the RBA started keeping track in 1976.

This despite the RBA’s cash rate having fallen from 3.50% in June 2012 to 2.75% in June 2013.

Merrills believes that while RBA cuts have not managed to spark lending growth, they have at least stabilised otherwise weak credit demand. The outlook remains clouded, nevertheless, as households continue to deleverage and business confidence continues to wallow. CIMB suggests business lending continues to slow on a cyclical basis, suggesting a cycle-up is still ahead, some time. Mortgage lending, on the other hand is structurally weak, reflecting an end to the big house, big mortgage frenzy of pre-GFC years.

Breaking down mortgage lending – the banks’ largest loan book percentage – sees NAB achieving 7.9% housing loan growth in the June quarter, ahead of ANZ (7.1%), CBA (6.7%) and Westpac (3.8%). Westpac’s low growth reflects the bank’s base SVR rate which remains materially above peers, JP Morgan notes. Having soaked up a lot of mortgages immediately after the GFC, Westpac appears to be continuing on a path of rebalancing its lending book break-down – one reason it is least preferred in the group by analysts.

On the other side of the ledger, Westpac nonetheless showed the greatest deposit growth in the June quarter at 7.4%, ahead of CBA (5.5%), ANZ (4.5%) and NAB (4.2%). Note that the deposit growth numbers are the diametric opposite of mortgage numbers in bank order. JP Morgan notes that while the banks recently chose to pass on at least the full RBA rate cut, falls in deposit rates were not commensurate. This implies bank net interest margins, a bank’s underlying life blood, have tightened.

Macquarie suggests that in such a low growth environment, improvements in bank product penetration and profitability are vital. The analysts find that Westpac dominates institutional product profitability at 40% above average, while ANZ and NAB dominate SME/corporate profitability, at 20% above average. Macquarie thus suggests ANZ and NAB have the greatest upside from increasing product penetration, and are the broker’s top two picks.

Another issue of concern in banking at present is the life insurance sector, a business banks also indulge in. AMP’s recent profit warning highlights, notes UBS, that the banks are also vulnerable to the elevated claims and policy lapses which have undermined AMP’s life earnings.

Banks also perform better in periods of central bank easing than they do as central banks tighten. This makes sense, given the intention of rate cuts is to encourage credit growth and the intention of rate hikes is to curb credit growth. While at least one more rate cut is expected from the RBA in the near future (Macquarie has predicted as many as three 25bps cuts yet to come), the reality is the bottom of the cycle is approaching at some stage. The RBA cash rate is already at an all-time low.

Deutsche Bank notes the banks have outperformed the broad market by an average 25% in the past five RBA rate cutting cycles. When the bottom of the cycle is established, banks outperform only mildly for three more months before giving way to underperformance over the next 12-18 months as rates rise again. Note that underperformance does not imply lower share prices or indeed, poor performance. It is merely a comparison to market, and in Australia’s case the big resources companies tend to shine in rate hike cycles (given rate hikes imply a strong economy), relegating the banks to underperformance in comparison.

Deutsche does note that there is no apparent correlation between Australian bank performance and US bond yields. Hence the Fed-related bounce in US Treasuries recently should not impact on Australia’s typical bank performance trends.

UBS continues to view Australia’s banks as “strong, well-managed, high quality companies”. The analysts remain concerned about some sectors of the economy but believe the weaker Aussie, RBA rate cuts, strong corporate balance sheets and a firming housing market provide a level of protection. The performance of banks is closely tied to the performance of the overall economy, and UBS suggests “unemployment remains key”.

Merrills has proven itself a little more pessimistic in recent forecasting, suggesting the Australian economy will struggle through its transition from mining-dependent to not. The analysts expect very low GDP growth numbers for FY14-15 and have suggested a 25% chance of actual recession (as measured by two quarters of negative growth). Under such a scenario, the risk of bad debts, and thus bank bad debt provisions growing again, provides an additional earnings risk for banks.

As for current bank valuations, Deutsche finds that at an absolute level and compared to the All Industrials index ex-banks, bank price/earnings ratios are broadly in line with historical averages coming out of rate cuts. On a comparison to the All Ordinaries, bank PEs are still higher than previous periods, but this is largely due to the more severe de-rating of the resources sector.

UBS suggests that at an average PE of 12.2x, 2.0x book value and offering 6.4% yield, the banks are “still not cheap”. But much of the “extreme valuation stretch” has been removed.

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