Australian Banks: Valuations Stretched

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Bank analysts all agree there is limited upside for Australian bank share prices since their recent re-rating.

– Subdued earnings outlook remains
– Picture at least brighter than 2016
– Capital raising risk has eased
– Consensus suggests limited upside
 

By Greg Peel

Remember the GFC? It was over eight years ago. In the wake of public bail-outs of “too big to fail” banks across the globe (but not in Australia, beyond a temporary deposit guarantee), the international bank regulator based in Basel decided banks deemed “too big to fail” must carry more capital as an offset to systemic risk.

How much capital? The Basel Committee sat down and started to figure that out. After eight years, and no doubt a sigh of relief there hasn’t been another GFC in the meantime, the Basel IV regulation updates were expected to be made known by around about now. But the news from Switzerland is committee members are struggling to find common ground. Hence Basel IV has been delayed. The committee has only had eight years to think about it.

We nearly did have another GFC, around this time last year. While US banks acted swiftly, post bail-outs, to rebuild their balance sheets, European banks did not. By this time last year, shares in European banks were sliding dangerously. And not just the shares of small Italian banks – when Deutsche Bank was hit with a massive US fine (also GFC-related, seven years on), there was a very real risk the one-time German leviathan would become insolvent. Switzerland’s iconic banks were also looking shaky.

Australian banks entered 2016 with a dire backdrop for the global banking sector. Adding insult to injury at a local level were tumbling commodity prices, a slowing Chinese economy, and an ambiguous suggestion from the local regulator, APRA, that the balance sheets of Australian banks will be required to be “unquestionably strong”. This suggested Australia’s big banks would need to carry even more capital than Basel IV levels, and thus threatened a very real risk of further capital raising requirement.

Just when it couldn’t get any worse, some local ‘big name” companies were hitting the wall, the New Zealand dairy industry was in crisis, and the economies of the Australian mining states were in a tailspin thanks to the end of the mining investment boom and the collapse of key commodity prices. After seven years of winding back GFC bad debt provisions and handing out those reserves as dividends, suddenly it looked if Australian banks may have to quickly top up provisions once more.

After flying so high on the “global search for yield” in the years leading up to 2016, Australian banks share prices were being trashed. To put things into perspective, Commonwealth Bank ((CBA)) opened the year on $85 (having seen $95 in 2015) and dropped to under $70 in August.

August represented the bottom in commodity prices. Earlier in the year, US regulators decided to reduce the fine they had imposed on Deutsche Bank. The second half of the year failed to produce any more “big name” defaults as had been the case in the first half. APRA eased back on its tough talk of earlier in the year, and while introducing housing investment loan restrictions, managed to ease fears of significant bank capital requirements. The banks, loaded up with mortgages, took advantage of further RBA rate cuts to “reprice” their mortgage books, meaning not passing on the full amount. Bank share prices consolidated.

Then in November, along came The Donald. The immediate response was a surge in US bond rates and a surge in the share prices of US banks. Trump would return the US to solid economic growth and that would be good for all the world. Bank shares rallied across the globe, including in Australia.

Commonwealth Bank is today trading at $85.

Australia is not the US

While significant, the share price recovery post US election for Australian banks has not been quite as spectacular as the rallies in the US and Europe. And with good reason.

Banks typically benefit from higher interest rates, as higher interest rates allow for wider spreads between borrowing rates and lending rates (net interest margin). Trump’s campaign promises have led to a “reflation” trade in the US on the prospect of better economic growth, sending interest rates rising and US banks shares rising in tow. However, higher interest rates are not necessarily a good thing for Australian banks right now.

Australia’s 26-year run of economic growth has led, notes UBS, to significant household leverage and inflated housing prices. The housing boom has the RBA worried. Would rising interest rates potentially trigger cascading mortgage defaults?

The good news on this front is there’s no sign of the RBA hiking rates anytime soon. But that same good news limits the opportunity for Australian banks to increase their net interest margins. The Australian economy may not have known an official recession since the nineties but there is little doubt pockets of recession have featured in various sectors. The rebound in commodity prices have been a saviour for the economy but we are not about to see another mining investment boom to the extent we did in the noughties. The housing sector has carried the can in recent years but will shortly cool.

The reality is a Trump-driven US economic recovery, if that is what is about to transpire, will not flow through significantly to Australia. This is particularly the case if Trump makes good on his protectionist threats. Australia is its own economy – hamstrung by fiscal stasis, at the mercy of the Chinese economy, and overly indebted at the household level.

So Australian banks are not about to shoot the lights out in 2017. Analysts agree that 2017 will be better than 2016, but not spectacularly so.

Remaining Subdued

Deutsche Bank’s analysts are forecasting an average of 2% earnings growth for the banking sector in FY17. That’s “relatively modest,” Deutsche notes, but it’s a lot better than the FY16 outcome of a -3% earnings decrease.

UBS has this week upgraded its earnings forecasts, but warns the “subdued medium term outlook remains”. Macquarie agrees the outlook has improved, but slow growth environment will likely only deliver low single digit earnings growth.

Macquarie believes the easing of competitive pressures between the banks for loans and deposits will mean net interest margins should be at least stable or may rise above consensus expectations. Morgan Stanley acknowledges an easing of competition, but believes margins will remain under modest pressure.

The bottom line is Australian households and businesses are not about to rush out and borrow heavily in 2017. Households are already up to their eyeballs and despite low rates, the economic environment is not sufficiently inspiring for businesses. In the meantime, the banks are currently undertaking what Citi describes as a one-in-thirty year IT upgrade phase which is elevating costs at a time revenues are limited.

A brighter picture nonetheless

One of the biggest concerns of 2016 was the likely need for the Big Banks to raise new capital, again, to satisfy global and local regulations. While there was disagreement among bank analysts throughout 2016 as to whether, and to what extent, fresh raisings would be necessary, all now agree the immediate threat has eased.

As to how long it will take the Basel Committee to agree on new capital requirements is anyone’s guess but given the delay, and the fact the committee has itself played down the potential harshness of new requirements, there is a greater possibility Australian banks can get by on organic capital growth and dividend reinvestment plans. And there’s always the possibility of further non-core divestments, such as selling off wealth management and life insurance divisions.

There remains the question of just what is meant by “unquestionably strong”, but APRA, too, has moved to allay fears. The regulator has suggested 2017 will be a year of consultation, suggesting no new requirements will be imposed before talking it through with the banks. Even then, the banks will be given plenty of time to comply. APRA can’t impose a capital buffer requirement over Basel regulations until the Basel regulations are known.

Another feature of 2016 was collapsing commodity prices, which threatened defaults on loans to the mining sector right through to defaults on the mortgages of former mineworkers. While many had decided by August commodity prices had likely bottomed, no one foresaw the strength of the rebound. Strike that particular risk off the list for now.

There still remain “pockets of weakness” in the Australian and New Zealand economies but these are not significant, and while the Dick Smiths of the world seemed to be dropping like flies early last year, it appears we just saw a coincidental blip in “big name” defaults rather than a trend. Bank analysts have factored in a cyclical rebound in bad & doubtful debts, but suggest earnings upside is a possibility if such assumptions prove too aggressive.

There also remains the possibility of earnings upside if the banks were further to “reprice” their mortgage books. A lot will depend on the RBA, and here the picture for the official cash rate has never been murkier.

On the one hand, we had the scare of the Australian economy suffering negative growth in the September quarter, following the scare of disinflation earlier in the year. We have also had, for a long time, expectations Australia’s unemployment rate must rise. But on the other hand, the recovery in commodity prices has eased fears on both counts.

Some, but not all, economists still expect the RBA will need to cut further. There is at least agreement that if the next move is up, it won’t be this year. A lot will depend on global rates, specifically the US, and thus the Trump effect. If the RBA does cut, another opportunity is provided for the banks to reprice mortgages.

So the upshot is risks have diminished for the banking sector, there may be upside opportunities, but the likely outcome is still a subdued credit growth environment in 2017. So where does that leave bank share price valuations?

All in the price

While the recovery in Australian bank share prices has not been quite as spectacular as those of offshore peers, it’s been a solid run nevertheless. At the very least, the valuation gap to the industrials sector, which had yawned at the depths last year, has all but been closed.

We have also seen a bit of a pullback from the highs in recent sessions, likely because one by one bank analysts have come out with reports suggesting the banks are now at least at fair value, all things considered, or overvalued given the outlook.

Macquarie pulled its sector view back to Neutral. UBS is currently maintaining a “relatively neutral view”. Deutsche suggests the brighter outlook is “largely in the price”. Morgan Stanley notes Australian bank valuation metrics look elevated compared to history. Last week Citi declared quite boldly “sun to set on bank share price rally”.

Shaw & Partners, not an FNArena database broker, has told institutional investors and short-term traders it’s time to sell, while long term investors should just ride it out. In other words, long term investors should not buy the banks unless lower share prices are on offer.

The recommendations and forecasts of the eight major brokers in the FNArena database are tabled below.
 

The first point of note is that CBA and National Bank ((NAB)) have exceeded consensus targets (based on yesterday’s closing prices). Westpac ((WBC)) and ANZ Bank ((ANZ)) are not far off. History shows that whenever targets are exceeded, a share price pullback follows unless analysts are given cause to upgrade their forecasts.

Judging by consensus of a subdued earnings outlook, the latter seems unlikely the case in the near term.

We also note a total of ten Buy (or equivalent) ratings, eighteen Hold and four Sell. While the number of Hold ratings is consistent with a general view of fair to overvaluation, ten Buys to four Sells appears contradictory, and indeed is not a lot different to the 13/17/2 Buy/Hold/Sell split in place in September last year (following bank reporting season). There are three points to note here.

Firstly, these are individual bank recommendations, relative to the sector. Secondly, analysts are always disinclined to offer Sell ratings given it upsets the company they are rating and potentially leads to limited access to management. Thirdly, stock brokers do not make money by encouraging investors to sell.

Next month will provide the opportunity for bank analysts to update their forecasts. CBA will report first half FY17 earnings while Westpac, NAB and ANZ will update on first quarter FY17 performance.

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