This story was first published with full access for subscribers only on March 7. Due to a technical error, now resolved, a large section of the story was omitted on first publication. FNArena is thus republishing the story to rectify the error, with access for all readers. Please note prices quoted are referenced from March 7.
- Banks trading above consensus target prices
- Mortgage pricing set to come under pressure
- Yields provide support
- Beware the election year
By Greg Peel
As Shaun Micallef noted recently on his satirical current affairs program, “If a week is a long time in politics, then six and a half months is a [expletive deleted] eternity”.
If it’s not bad enough that the longest running election campaign in Australian history has now begun, and that we’ll all be subjected to months of attack ads and generally relentless waves of nausea, those of us not living in four particular electorates in Sydney effectively have no vote. Low mortgage rate demands and attacks on banks will be dominant features despite the ever growing cohort of Australians relying heavily on interest income.
Australian banks will soon be feeling, if they’re not already, like bushwalkers in a NSW state forest wearing targets on their backs. Last week former RBA governor Bernie Fraser criticised the big banks for putting shareholders ahead of customers by not cutting mortgage rates when there’s plenty of scope to do so. The banks, he implied, have become just too profitable.
Research from UBS, among others, supports Fraser’s profitability claim. Twelve months ago, UBS notes, Australian banks were actually losing money on new mortgages. Banks’ cost of funding has nevertheless dramatically reduced in the interim, to the point of which “writing new wholesale funded home loans has never been more profitable,” the analysts declare.
Such public debate from Fraser is exactly the sort of fuel that will help fire up the familiar bank collusion claims from politicians that will help whip the masses into a frenzy during the election campaign. Twelve months ago, as UBS would attest, the banks had due cause not to cut their mortgage rates by as much as the RBA was cutting its cash rate. Today that is not the case. The last thing Australian banks need is actual political interference. They know full well the cretins in Canberra these days would sell their mothers for electoral victory, and thus would have no qualms in satisfying the blood lust of the great unwashed. (Even though every working Australian is by default a bank shareholder, unless they choose otherwise.)
Ironically, the banks have arguably never been more competitive. Australia’s electorally limited focus on borrowing rates ignores the fact the banks have not been dropping their deposit rates by levels implied by RBA cuts either. Those Australians not living exclusively in swing seats have been beholden to term deposit rates for a few years now, and on balance those seeking income have done well. Fierce competition among banks for deposits, which offer cheaper funding for the banks than offshore wholesale borrowing, has ensured comparatively attractive returns on one of the safest possible investments.
Unfortunately for retirees, those days are now numbered. Wholesale funding costs, as noted, have fallen. The need for banks to offer above-market deposit rates has diminished, and already rate reductions are sneaking in. We know that banks can be competitive – look at NAB’s “Your dumped” campaign, which successfully parodied Australia’s lack-of-competition obsession, and ANZ’s decision to no longer tie its lending rates to the RBA cash rate, as well as the deposit war. We also know they do tend to hold staring competitions when it comes to mortgage rate reductions. When one blinks, finally they all blink.
They haven’t blinked, yet.
Which has been great news for shareholders. As the recent interim result releases and quarterly updates from the banks attest, bank earnings have grown despite little to no growth in lending books. Aside from operational cost cutting, growth has come from cheaper funding. Solid earnings have allowed the banks to maintain attractive, fully franked dividends. And the investment community, both domestic and international, has been very hungry for yield. The result? The following is a chart of the ASX financials ex-REITs sector (note that the big banks very much dominate the weightings within this index):
That’s a 25% return since mid-November which equates to about 92% per annum assuming, of course, the same rate of appreciation continues for another eight and a half months. And that’s the question now for bank investors, and particularly for those wondering whether now might be a good time to jump on the bank bandwagon.
Longer term readers of FNArena will be aware that for many years a reliable indicator was provided by the FNArena Icarus Signal with regard to banks. When bank shares prices moved to exceed broker consensus target prices, one of two things always followed. Either brokers upgraded their targets, or bank share prices corrected. In most cases, it was the latter which transpired.
Last year we began warning readers that the dynamic had changed, implying that the once reliable indicator would now be compromised. Bank share prices have been rising pretty much for one reason and one reason alone – yield. Rising bank share prices mean falling entry yields, but RBA rate cuts and subsequent reductions in yields offered by fixed interest investments (including term deposits, although competition has kept these elevated as noted above) ensure bank yield premiums have remained attractive. This is particularly so for domestic investors who enjoy full franking of bank dividends, but also true for offshore investors who are comparing yields on four of the safest banks in the world to the negative real rates being offered on fixed interest investments at home.
The yield factor has made Australian bank shares more attractive, implying a rise in sentiment towards bank shares despite little growth in bank lending books. Rising sentiment means higher PE multiples, or in other words, higher prices paid for the level of earnings on offer. When multiples expand, brokers upgrade their share price targets accordingly. The result season just past has evoked widespread target price increases driven by analysts playing PE catch-up. Banks have been no exception.
Thus in regards to FNArena’s once reliable indicator, bank shares prices have for months now been trading above consensus target prices. This time it is the analysts who have relented, chasing share prices higher with rising target prices. But if there is one definitive time when analysts can feel most comfortable about target price settings, it is immediately following company earnings results and updates. Last month provided such an opportunity, and bank target prices have shifted up accordingly.
Yet new consensus target prices remain below current bank share prices.
The following table outlines the situation:
As at yesterday’s closing prices, ANZ Bank ((ANZ)) is trading around 5% above target, National Bank ((NAB)) around 7% and the larger Westpac ((WBC)) and Commonwealth Bank ((CBA)) around 10%. Yields remain attractive on a comparative basis at 5.1-6.0% (particularly fully franked) but not as attractive as they were three months ago.
If the RBA cuts further, those yields will be more attractive, but right now the central bank seems comfortable with its policy settings. For bank share prices to rise further, sentiment will need to continue on its upward trajectory. For stock analysts to raise their target prices further, either sentiment or bank earnings will need to rise. Otherwise we’re back to the more familiar implications of the FNArena Icarus Signal – bank prices will need to pull back.
It is nevertheless likely that yield will provide support, at least restricting the downside to bank share prices if not driving prices higher. In terms of sentiment driving prices higher, two weeks ago UBS noted that at a bank sector forward PE of 13.3x and a price to book value of 2x, the market is “over-extrapolating” the upside risks. Today that PE exceeds 14x.
In terms of earnings growth potential, it must be noted that banks don’t only make money from mortgages. Banks also lend to consumers and businesses. Retail sales may have picked up a little from low levels but the December quarter GDP figures showed household consumption remained subdued, which flows onto lower subdued levels of consumer credit demand. Private sector business investment also remains stubbornly subdued, again implying low demand for business borrowings. If the global economy continues to show signs of improvement, then business lending should slowly start to rise and, later down the track, household borrowing should start recovering as well. Analysts have factored these possibilities into their valuations.
A better looking global economy has also clearly helped to drive the rally in risk assets, and when risk assets rise, wealth managers benefit from increased inflows and performance. This is another source of earnings for wealth manager banks.
Then we come back to mortgages. The banks have benefitted over the past 18 months from “mortgage repricing”, in other words by picking up added net interest margin by not cutting lending rates by as much as the RBA has cut its cash rate. Banks are not going to raise their lending rates, so they would need to wait for another RBA cut to sneak in additional margin with more short-changing. The RBA appears to be on hold, which suggests it might be months before another opportunity arises. But were the banks to continue short-changing, in an election year..?
“The risk of ‘political interference’,” warns UBS, “is real”.
The pressure is thus on for banks to start offering cheaper mortgages. This is more so the case if the global economy continues to improve, funding costs continue to fall, and competition for deposits eases. Cheaper mortgages mean, all things being equal, lower levels of earnings. If one bank blinks then it is likely they’ll all blink, and now financier Yellow Brick Road ((YBR)) is teaming up with Macquarie Group ((MQG)) to take on the Big Banks in the mortgage game. Forced competition. It is interesting to recall that back in the early nineties, Macquarie was a leader in the development of local mortgage-backed securities, and one of the primary sources of those mortgages was a guy known as Aussie John Symond, who famously took on the “sharks”. The Australian mortgage market subsequently underwent an upheaval, to the detriment of the smug banks.
If we assume the global economy will continue to recover (if we have a macro “event”, bank stocks will be amongst the first sold off), then any pressure on bank mortgage pricing may be offset by gains elsewhere, such as increased demand for other lending and increasing wealth management inflows. These are factors which bank analysts must weigh up when ascribing their valuations.
Returning to the table above, we can do a quick calculation and note that of 28 recommendations (four banks, eight FNArena database brokers), we have 11 Buys, 14 Holds and 7 Sells. Collectively we could say the ratio is thus 11:21 (52%) “do not sell here” and 7:25 (28%) “do not buy here”. Yet collectively, every bank is trading above consensus target. Surely this would imply more Sells than Buys?
Target consensus ignores target range, and different brokers still have higher targets than share prices for different banks. Hence the Buy ratings in the mix. Brokers also assume the investor needs to hold bank shares (index portfolio), thus ratings offer recommendations within the sector, for example Buy ANZ but sell CBA. Broker recommendations are always “Buy-biased”, because brokers don’t make money by telling clients not to buy things. Having said that, Bridge Street is littered with the corpses of bank analysts with longstanding Sell ratings on a supposedly overpriced CBA. And they’re at it again.
Macquarie currently prefers the offshore-exposed banks (ANZ, NAB) over the big retail banks (WBC, CBA, major holders of mortgages), suggesting “the playing field is likely to level out given we believe it will become harder to reprice mortgages”. The analysts believe mortgage repricing to date is already reflected in share prices.
Morgan Stanley, on the other hand, believes ANZ’s international and institutional banking does not provide sufficient growth to compensate for the bank’s falling return on equity, comparatively high risk profile, underweight position in retail banking, lower than peer yield and stretched PE.
JP Morgan believes that the ongoing reduction in wholesale funding cost (which reflects less concern over further macroeconomic disaster) will allow the banks to start reducing their deposit rates to offset forced reductions in mortgage rates. In other words, JPM sees the banks “managing” their profitability rather than growing earnings in FY13. The opportunity for improved earnings will come in FY14-15. (Note: CBA’s FY13 ends June, ANZ, NAB and Westpac run on a September year-end.)
UBS is concerned that “share prices have detached from fundamentals”.
UBS is right – share prices have detached from fundamentals and arguably did so a while back, as soon as “yield” became the Holy Grail. As long as the banks don’t reduce their payout ratios (suicide) then sustainable yields will either require sustainable earnings or, for the new investor, lower share prices.
If we add up all of the above, no one in the analyst community is prepared to call a big Sector Sell on the Big Banks. If we dismiss any further macro “events” (Italy withdraws from eurozone, US debt ceiling causes further credit downgrade, Israel launches a pre-emptive strike on Iran, insert unforeseen event here), then the upside/downside balance is finely weighted. Valuations are overstretched on near term earnings growth potential given increased sentiment driven by the search for yield. That search is not over, thus any pullback in bank valuations should quickly spark renewed support.
Do you buy banks here? It depends how much you value the yield on offer over the longer time frame.
A last word, on the regional banks. In the rally shown in the chart at the top, regional banks Bendigo & Adelaide Bank ((BEN)) and Bank of Queensland ((BOQ)) have outperformed the Big Banks by 5%, driven, JP Morgan notes, by the falling cost of RMBS (residential mortgage backed security) funding. Prior to the GFC, RMBS was the lifeblood of the smaller lender.
JP Morgan notes BEN and BOQ are now trading at an equivalent yield to the majors and, on the analysts’ reckoning, premium valuations. Higher risk little banks are not meant to be worth more on equal terms than lower risk big banks.
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