Australia’s self-directed investors are understandably concerned about the outlook for Australian bank shares in this economic and political environment. But is this justified? In this article, we analyse the issues that are likely to affect the banks, their share prices and dividends over the next few years.
At the outset, we note that the seeds for the current troublesome trading environment for the banking sector were sowed over the last decade. Many of the responses and policies of central banks and governments in the immediate aftermath of the GFC continue today. Why this is so, is subject to much conjecture – but they continue to have ramifications for banks and investors alike.
The biggest issue confronting banking operations and business will be the unwinding of the excessively easy monetary policy settings by central banks in the US, Europe and Japan. These policies, including both QE and zero-based interest rate settings, have gone on far too long. Further, they have infiltrated and seemingly direct Australia’s monetary settings.
Australia’s open economy, particularly seen in terms of the offshore capital flows that fund our growing debt levels, has ensured that we are hostage to overseas monetary settings. Our compliant adherence to an open economy political philosophy, while the rest of the world prints money to fund debts that will never be repaid, has severe consequences that affect our economic well-being and, in particular, the outlook for the Australian banks.
While current low interest rates in Australia appear relatively high in comparison with overseas economies, they are oppressively low for long-term savers – particularly for the superannuation funds designed to meet our long-term pension liabilities. The first chart below shows that Australia’s historically low ten-year bond yield still sits above that of many countries with inferior credit ratings.
Figure 1. 10-year bond yields
The next chart is even more stark, as it puts our rates, across the bond yield curve, into context. While Australia’s rates are historically low, our AAA credit rating does not ensure that we pay less for debt than, say, Italy (BBB-). The grossly over-indebted Japanese government pays far less for debt than we do.
Figure 2. Bond yield curve, 2018 and beyond
However, the above need not have been so. Had we set an appropriate vision and strategy for Australia to counter these factors, our economic management would have naturally flowed in response to offshore events. For instance, we could have restricted the foreign ownership of Commonwealth bonds. Or we could have restricted foreign investment in residential property. We didn’t, and so now we have to deal with some of the following painful consequences:
1. A Commonwealth Budget that seemingly cannot be balanced;
2. A trillion dollars of net foreign indebtedness, representing 60% of GDP;
3. Household debt that, when measured against household income (at 170%), is amongst the highest in the developed world (see chart below);
4. Housing affordability in south east Australia at arguably its worst ever level; and
5. The creation of a financial sector, most notably our big 4 banks, which represent both an excessive size relative to our GDP and as a proportion of our stock market. We have created banks that are too big to fail.
Figure 3. Household finances, per cent of household disposable income
Source. ABS; RBA
This is not to ignore that Australia would have experienced some pain without the illusory benefits of low interest rates and abundant foreign capital. Clearly, we would have had higher interest rates; however, that would have enforced an economic reality on our economy and checked excesses.
Australia, like much of the western world, has ducked the economic imperative to deal with excessive debt. We have benefited from excessively low interest rates, but have used this to create yet more debt. We could have used debt more productively – to invest heavily in strategic infrastructure – but we didn’t. The pain flowing from funding our own future from our own savings would be far preferable to the problems that we now potentially face in dealing with foreign creditors.
It is indeed interesting to note that despite our excessive foreign and household debt, Australia’s superannuation assets now exceed $2.2 trillion. These are well in excess of our net foreign indebtedness of $1 trillion. Our superannuation assets actually exceed Commonwealth debt by 400%. It is arguable that Australia has unnecessarily drawn down foreign debt when we could have utilised our own patient capital.
Meanwhile, the rest of the world continues to print money and support fractured financial systems. At the end of May 2017, it is estimated that the balance sheets of the world’s major central banks reached an all-time record of US$15 trillion. These balance sheets have expanded by over US$1.5 trillion this year alone. It is clear that the major international central banks have a policy to buy as much Government debt as possible. These actions have distorted and corrupted global bond and interest rate markets, and no doubt Australia’s bond yields are a result of these policies.
Finally, and importantly, we make this crucial observation that exemplifies our caution regarding the pricing of all investment assets – let alone bank shares:
There is no evidence that the world’s Central Banks have a strategy to unwind their policies. They have taken the world on an exploratory journey that is now causing a range of profound economic and asset pricing problems. It may well be too late to adjust interest rates and so economic and market price normality is not likely to return for many years.
The current environment for our banks
The introduction should suggest to investors that Australia’s current low interest rates do not imply a benign economy with low risk. To the contrary, low or negative “real” interest rates (below inflation) have created an elevated risk for investors. This is because our interest rates are the result of international manipulation rather than economic reality. At some future point, today’s low interest rates will rise and challenge the value of all assets. In this environment, capital maintenance should become every investor’s mantra.
Bank investors – focused on yield, enhanced by franking – need to consider the economic environment. Low interest rates and booming residential property prices are not markers for economic success, but rather economic excess. The banks have benefited from both the provision of abundant cheap debt to households and property speculators willing to borrow excessively.
While the following chart suggests that residential property prices are moderately elevated at 14% above their long-term trend – this is an average. It seriously understates the excesses in Sydney and Melbourne.
Figure 4. Australian house prices relative to their long-term trend
Housing prices are significant for the operational risk of banks as they are the economy’s prime financial intermediaries. Property represents the primary security for the overwhelming majority of bank loans. The banks raise funding through deposits and wholesale funding markets, and lend to borrowers (across sectors, but with a focus on residential property). In doing so, they must generate a margin which is primarily represented by the differential between interest paid and interest earned.
The recent history of “net interest margins” is represented in the following chart which shows a continual decline for the last 20 years. To offset this decline and so grow profits, the banks have covertly increased the leverage on their balance sheets. They have lent more against their capital bases by adjusting down the risk weighting of their mortgage books. In recent times, the financial regulator (APRA) has examined this approach and directed the banks to increase their equity and reduce speculative lending.
Figure 5. Major banks’ net interest margin*, domestic, half-yearly
Source. Banks’ Financial Reports, RBA
Supporting their business is shareholder capital, which normally generates a leveraged return in the range of 12% to 18% per annum. This is shown in the next chart which tracks the return on shareholders equity (profitability) of Australia’s banks. We can see that the banks have experienced a decline in their profitability (as distinct from profits) from the peak reached just prior to the GFC. The chart also shows the effect of the severe recession of 1992 which obliterated the equity of both Westpac and ANZ. Investors need to understand bank leverage, for it magnifies returns in both good and bad times.
Figure 6. Australian bank profitability*, return on shareholders equity after tax and minority interests
Source. APRA; Banks’ annual reports; RBA
Shareholders equity is a regulated buffer, necessary to ensure the stability of the financial system as a backstop for banks in an economic downturn. The confidence of the providers of funding to the banks (mainly retail depositors) is driven by the perceived strength of the banks. Some of the key elements of confidence flow from long-term financial performance (from 1993), perceived good governance, strong capital ratios and the “implicit guarantee” of their deposits by the Australian Government. This latter point is subject to much discussion, but the recently announced bank levy was partly justified by the guarantee.
The next chart shows that the level of retail deposit funding of the banks has lifted substantially since the GFC. During the GFC, the banks were exposed by their high levels of wholesale funding, particularly those drawn from international markets, which, at the peak of the financial crisis, were severely disrupted. Should there be another extreme international event, our banks appear to be far better funded than at any time in the last 20 years.
Figure 7. Funding composition of banks in Australia*, share of total funding
Source. APRA; RBA; Standard and Poor’s
As we noted earlier, the Australian economy has drawn substantial capital and debt from foreign sources (net $1 trillion) and of this amount Australian banks account for about $600 billion in foreign wholesale funding. Their costs of funding will continue to be directly affected by international events. For instance, when President Trump was elected in November, the wholesale debt market reacted by increasing interest rates due to a perception of a rising risk of Trump-generated inflation.
We noted above that Australia’s regulators have progressively increased their regulation of the banks’ capital bases. The full force of the GFC did not take Australia into recession, but it exposed the risky underbelly of the Australian financial system – excessive leverage to offshore funding.
The next chart shows the substantial improvement in the capital bases of our banks and the focus on equity (tier 1) rather than subordinated debt (tier 2).
Figure 8. Capital ratios*, consolidated global operations of locally incorporated ADIs
The offset to increased equity or capital is the declining return on equity. While banks are reporting near record profits, well above the levels prior to the GFC, their profitability (ie return on equity) has declined.
Figure 9. Australian bank profits
Source. APRA; RBA
The outlook for bank shares
As noted above, the banks have endured declining interest margins and declining returns on equity for the last decade. Looking forward, we perceive that interest margins are likely to hold and possibly rise as commercial reality dictates. We have recently seen the adjustment of interest rates (for instance, interest only loans) in response to tightening APRA regulations. To grow profits and maintain profitability, the banks need to be more focused on pricing risk rather than growing assets. That, in our view, is a good outcome – but it is belated.
Possibly the real determinant for banks is reflected in our next chart. It will be a decline in the performance of bank assets (loans) that will hit their profits. Should assets move into the non-performing category, then interest income will be lost and write-offs occur. The potential for non-performing assets to appear comes back to the environment outlined in our opening commentary.
Figure 10. Banks’ non-performing assets, domestic books
Source. APRA; RBA
The unwinding of low interest rates across the world – as it flows through to mortgage rates and residential property prices – could become the first serious pressure point for the banks. While there are no signs that the European or Japanese central banks are keen to normalize interest rates just yet, it is clear that the US Federal Reserve (Fed) has begun the process. The Fed has acknowledged that US rates are too low at this point in their cycle, but the adjustment upwards is being checked by their peers, and by the fear of stymying the already anaemic US recovery.
In preparation for the inevitable interest rate rises that await us in the next few years, APRA has been enforcing stricter (higher) capital ratios to ensure the banks’ capital buffers are as high as prudently possible, that is, they must be “unquestionably strong”. Time will tell if the highly leveraged household sector can cope with mortgage rate rises.
The excesses of the debt driven property cycle in Australia are playing out. However, because they have occurred during a period of historically low interest rates, the work through (or work-out) is likely to be more convoluted.
Figure 11. Australian housing lending rates, average interest rate on variable rate loans
Source. ABS; APRA; Perpetual; RBA
Our many charts presented above show that during this cycle, household debt grew faster than any previous cycle and so have the property prices in our most populous cities. The level of indebtedness flowed from cheap international wholesale funding transferred through banks’ balance sheets and the availability of cheap loans to property investors. At the bottom of the interest rate cycle, we saw peak levels of debt, high bank profits and high bank share prices.
Bank prices were pushed higher, not because of improved profitability, but by passive yield-chasing investors forced out of conservative bank deposits into bank shares and hybrid securities. This transfer of investment capital was also stimulated by franking credits which enhanced bank share yields.
Are the recent bank share price corrections a taste of things to come?
First, we note that the slide in share prices occurred directly after the Commonwealth budget announced the bank levy. This was a direct attack on the high profits of the Australian banks and an acknowledgement that they have become too big for the Australian economy. The bank levy made it clear that an implicit deposit guarantee exists for Australia’s largest banks. However, that guarantee comes at a cost – which just happens to raise much needed tax revenue.
Second, the bank levy is to be applied to the liabilities of the banks, and not their profits. This was a clear sign that the growth of our major banks is intended to be checked. It may be a somewhat haphazard attempt, drawn from overseas precedents, but the intention seems clear. It again acknowledges that Government guarantees cannot be open ended.
Third, the directives of APRA to bolster bank capital ratios to ensure that they have excess capital to ward off the effects of higher interest rates and/or a severe residential property correction are evident. The pressing issue for the banks is how to grow and maintain this excess capital. Apart from raising new equity (which dilutes earnings), the more logical way is to grow retained earnings by adjusting down dividend payout ratios.
So our view is this. The banks will collectively realize that payout ratios are too high and that retaining earnings is their most sensible capital management approach. As bank balance sheets are checked by the economic cycle and government intervention, the banks will realize that share price growth will only occur if they limit share issues.
Bank investors and share prices will adjust to lower dividends, but with the potential for them to grow on a sustainable basis. Of course, this outlook could be affected by an unforeseen event – particularly one emanating from overseas – but frankly that is always the risk in today’s unpredictable world.