- Earnings disappointment
- Capital issues
- Rate rise risk
- Time to buy?
By Greg Peel
FNArena’s preview to this month’s bank results season, Australian Banks: Stuck In The Middle With You, noted analysts considered further upside risk to bank share prices to be limited based on lofty valuations and downside risk to be heightened due to a number of factors. These included subdued earnings growth expectations, tighter net interest margin spreads, the normalisation of bad debts and the need for the banks to improve their regulatory capital positions.
Yet analysts did not consider downside risk to be dramatic, given lower bank share prices imply increased dividend yields on purchase, and the post-GFC investment world is all about yield.
Bank share prices began to stall in mid-April after a strong March quarter as the oxygen became rather thin, but it was Westpac’s ((WBC)) result at the beginning of May that sparked the first big drop, and on a net basis bank share prices have dropped ever since. The ASX Financials ex-REITs sector, which is dominated by the Big Four, has fallen 18% from its peak. Dramatic? Surely that has to be.
Stormy Weather
To be fair to bank analysts, disappointing earnings results from the majors have not been the only catalyst for the pullback.
In the same period we have seen a sudden (yield) rebound in what had become a very overbought European government bond market, with a surging German ten-year yield very much the focus. This has been blamed for an unexpected bounce in the US ten-year yield when weak US data would suggest otherwise. When yields adjust around the developed world they float all boats on an interest rate differential basis, hence Australia’s ten-year also suddenly bounced.
This bounce came despite the market expecting, and subsequently receiving, another RBA cash rate cut, but the cut itself was rather overlooked when the language of the RBA policy statement seemed to imply, by omission, no more rate cuts would be forthcoming.
This assumption has since been dismissed by the RBA but by the same token, the central bank has stepped up its language with regard its fears brought about by the Sydney house price bubble. To date APRA has only modestly tightened its lending rules, and given this has had no impact, it is assumed APRA may be close to implementing further restrictions.
More on that in a moment.
The other cloud hanging over the banking sector has been that of last year’s Financial Services Inquiry recommendations with regard increased bank capital requirements. Given the FSI report was delivered in November and the Treasurer is yet to act upon it, initial market fears faded into 2015 the longer nothing seemed to happen. But when National Bank ((NAB)) announced a capital raising – Australia’s biggest ever – at its result announcement, suddenly capital requirements were very much in focus once more. The size of the raising lent itself more to NAB’s intention to float off its underperforming UK business, but management did declare that a portion would also be used to shore up the bank’s balance sheet ahead of expected capital requirement increases.
Analysts believe that Westpac and ANZ Bank ((ANZ)) will soon be forced to follow suit, and maybe Commonwealth Bank ((CBA)) as well, albeit CBA is currently in a superior capital position.
So with regard the recent fall in bank share prices, we can trot out the old “perfect storm” analogy. But let’s go back to the primary reason bank analysts were suggesting downside risk prior to the reporting season – actual earnings.
Disappointing
Ahead of the season, analysts were expecting “subdued” first half earnings growth. The result was a net decline of 0.8%. There’s your Goodnight Sweetheart moment right there. UBS has broken down the numbers.
Revenues rose by a respectable 2.4%, UBS notes, but were boosted by Aussie dollar weakness (+0.8) and improved trading income (+0.2%). Underlying revenue rose a disappointing 1.3%. Increased costs bit into earnings (-1.1%) and, just as analysts had warned, bad charges have stopped falling and started rising once more (-1.0%). Throw in higher tax rates and adverse movements in non-US exchange rates and at a net minus 0.8%, the banks marked their first earnings decline since 2009, the year of the GFC fallout.
Not only do lower earnings per share by default imply lower dividends per share (the banks operate on payout ratios), increased capital requirements imply earnings being redirected away from dividends. NAB went down the direct capital raising path, but Westpac’s unsterilized dividend reinvestment plan (DRP) implied a backdoor raising and subsequent dividend per share dilution.
And special dividends are now but a distant dream.
Suddenly, one might say with regard bank earnings reports, the Emperor has no clothes.
Not that the Emperor was really running around kit-off in the first place. Underlying bank earnings growth has quite simply been “subdued” since the GFC, as one might expect. There was an initial flurry as banks increased their mortgage books back when the then Labor government offered homebuyer hand-outs and allowed the Big Banks to swallow smaller banks, but this was soon undermined when a war broke out to secure increased deposit bases.
The RBA has helped by lowering rates over the period to allow “asset repricing”, which is bank-speak for not cutting lending rates by as much as the RBA’s 25 basis points at each move. But lower cash rates mean lower absolute margins (it’s easier to add more margin to 7% than 2%) and competition has ensured net interest margins (lending rate minus deposit rate) have remained tight. This is a bank’s bread and butter.
Analysts have warned for some time that the “BDD cycle” was nearing a turning point after six post-GFC years. This is the level of “bad & doubtful debts” on banks’ lending books which have been coming down over that period, allowing the return of BDD provisions to the P&L, and thus have provided the primary source of bank dividend increases. The first half 2015 will likely mark the end of this cycle, Citi suggests, and all brokers are in agreement.
Citi is nevertheless not so convinced as others that the other three banks will need to rush down the capital raising path. Aside from NAB having a unique need to increase capital, beyond regulatory considerations, the broker suggests the financial system stability argument behind the new international banking rules soon to be implemented (Basel 4) is undermined by a lack of clarity on the final rules, and will probably come with a multi-year implementation period anyway.
Basel 4 will impose an additional capital requirement upon global banks deemed “too big to fail”, to use the vernacular, within their own domestic banking systems. This means Australia’s Big Four. But the FSI has recommended an additional capital buffer specifically for Australia’s banks given Australia’s relative “smallness”, (ditto).
Citi also believes the banks will attempt to remain protective of their dividend yields, so they won’t be rushing out to make pre-emptive capital increases.
Citi may be right but analyst in general concede that there remains a capital risk cloud hanging over Australian banks, which NAB simply served to remind the market of. Deutsche Bank notes that not only were the banks’ earnings results in the first half disappointing, their capital generation over the period also fell short of expectation.
Now, back to APRA, as promised.
Auckland Rules
The RBA’s problem is that monetary policy via cash rate setting is an all-encompassing blunt tool. Hence the central bank’s attempts to bolster the Australian economy have resulted in the side effect of the runaway housing market. Each cut only makes this worse, but then regulatory comrade APRA does have the power to target the lending market specifically.
Thus earlier in the year, APRA tightened restrictions on banks by insisting they could not grow their investment mortgage books by more than 10% per year. Fat lot of good that’s done, one might argue, given Sydney house prices are up around 30% over two years and do not yet look like stalling. The banks have responded by discounting mortgage rates for owner-occupiers, thus adding more fuel to the fire.
But again there is a blunt tool issue. The bubble is really only in Sydney. There has been some demand for housing in Melbourne, for some reason, but in other capital cities house prices are flat to falling. APRA can’t simply single out the Sydney market for increased lending restrictions, can it?
Well, once again we may need to look across the Ditch for a lead. The RBNZ was the first to move on introducing so-called “macro-prudential controls” for a bubbling New Zealand housing market, which prompted talk at the time the RBA/APRA may need to follow suit. Now the RBNZ has further tightened its rules to include a minimum 30% deposit requirement for investors, on top of the 10% investor loan growth restriction on banks previously applied. But the catch is, only in Auckland.
Indeed, outside of the “Sydney of New Zealand”, that investor loan growth restriction has been eased to 15%.
So, it can be done. Macquarie would not be surprised if APRA were forced to implement a similar set of Sydney-only restrictions. CBA and Westpac have the greatest exposure to Sydney, Macquarie determines, followed by ANZ and then NAB.
Finally, let us not forget that ahead of the budget release there had been talk of a possible revenue raiser for the government being introduced in the form of a bank deposit tax. Never mind that depositors already pay tax on their interest when stock market investors enjoy a level of franking on dividends to varying degrees, and never mind that such a tax would impact on the growing cohort of retirees trying to get by on meagre interest payments. They’re not the ones who elect governments in Australia, mortgage belt electorates do.
There was no mention of a deposit tax in the budget, but that is not to say the Treasurer has dismissed the possibility. The issue of a deposit tax was raised in the FSI and that has yet to be addressed by the government, implying “watch this space”. Credit Suisse suggests were such a tax imposed, CBA and Westpac would be most impacted and ANZ least.
Valuation
So there is little doubt there are several clouds hanging over the Australian banking sector at present. But as noted, the ASX financial sector has fallen 18% from its peak. We recall that FNArena’s bank reporting season preview, Stuck In The Middle With You, noted that analysts did not see bank share price downside as being dramatic given the yield support that kicks in at lower price levels, acting as a safety net.
Have we fallen far enough?
UBS’ equity strategists argue that the banks are probably now oversold, in the short term. Disappointing first half earnings results have, to date, not led to significant full-year forecast cuts from analysts. Price/earnings measures now look more attractive at these lower price levels. The May RBA rate cut provides support and while the BDD cycle may have turned, the bad debt outlook remains benign.
Things may be different in the medium term, nevertheless. It is historically proven, UBS notes, at least over the past 20 years or so, that banks tend to outperform the broader market in periods of falling interest rates, and vice versa. Interest rates globally are, at present, on the move back up after having fallen steadily since the GFC. It may yet prove to be a head fake, but given most commentators agree global bonds have been seriously overbought it looks like this “bubble” may now be set to deflate.
Let’s face it, there’s not a lot further one can go down from zero, aside from implementing QE. The ECB was the only major economy left to go down the QE path (China has its own way of doing things). History suggests the relative size of the US and Australian economies imply at least a 200 basis point differential between their cash rates, and the US is at zero (effectively) and we are now at 2% (ie, 200 basis points).
The Fed is expected to raise its cash rate soon(ish). The RBA may have reached its limit. The bottom line is that in the years to come, global interest rates are more likely to rise than fall.
So is it all over for the banks? No. If the RBA starts raising it would imply the Australian economy is improving, which should flow through to increased credit demand and thus increased bank earnings. Moreover, at 5-6%, it will take several rate rises before bank dividend yields stop looking relatively attractive.
What is, arguably, over, are the days of wine and roses bank investors have enjoyed on the Australian stock market these past few years. Banks are not meant to be star performers, they’re meant to be “defensive” stocks.
Which Bank?
It terms of individual bank preferences amongst brokers, there has been little change in FY15-16 earnings and dividend growth forecasts post-reporting season from pre-reporting season. Dividend yields have ticked up slightly on lower share prices. What has changed is order of preference. Prior to the season, FNArena database broker consensus preference ran in the order NAB, ANZ, CBA, WBC. Now, as the table below indicates, it has altered to be ANZ, NAB, WBC, CBA.
Preference for ANZ is reflected in that bank having the greatest upside to the consensus target price, while least preferred CBA has the least. This breaks down when we see NAB preferred over Westpac despite Westpac offering greater upside, but we must remember NAB has already moved on its capital position.
I would have to check, but I would wager that the net upside to target is by far the highest it has been in three years, if not longer. For most of that period, trading prices have exceeded targets. This should imply, on FNArena’s experience, that the banks are now undervalued.
This would only change were analysts to be forced into cutting their price targets, but given they have just adjusted them for earnings results, there seems no obvious catalyst to do so in the near term.
Technical limitations
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