One of the most important drivers of economic growth is the credit cycle and it’s vitally important to understand the point in the cycle we are currently witnessing and, with a particular focus on risk, to position your portfolio accordingly.
Reporting season highlighted that we are firmly in the “Late cycle” phase of the credit cycle with evidence suggesting that stress is beginning to build up in the economy, albeit from extremely low levels.
Supporting this observation is the performance of a number of financial institutions that are either operating ‘up the risk curve’ or those companies that are smaller/less diversified across business/lending lines. Two such examples of this were the February financial results from:
- Genworth Mortgage Insurance Australia Limited (ASX:GMA) – GMA operates a Lenders Mortgage Insurance business, providing insurance to lenders for losses due to defaults of a mortgage loan; and
- Bendigo and Adelaide Bank Limited (ASX:BEN) – BEN is a regional bank with a loan portfolio weighted towards Victoria.
Genworth Mortgage Insurance Australian (GMA)
During reporting season, GMA recorded a 20% fall in its insurance profits for FY16. Whilst part of the reason for the fall in earnings was the loss of a key contract with a client, the result also highlighted a significant increase in the claims incurred (41% YoY) with the business citing rising delinquency rates across geographies, particularly WA together with the rising underemployment in the economy.
GMA Management have also revised down their expectations of a recovery in WA with softness expected to last at least another 18 months.
Source: GMA FY16 Financial Results presentation
Bendigo and Adelaide Bank (BEN)
BEN reported an underwhelming 1H17 result with cash earnings remaining broadly flat on a prior-comparison-period basis. Whilst BEN did grow the loan book over this period by a factor of close to 2x system growth, the increase (93.2% pcp) in impairment expenses offset this growth.
Source: BEN 1H17 Financial Results presentation
While these impairments are at low levels, areas of concern coming out of the result include:
- BEN has a large exposure to Great Southern Group (refer to https://en.wikipedia.org/wiki/Great_Southern_Group for more info) amounting to ~$130m (down from ~$500m in 2009) – typically the last part of the loan book is the hardest to recoup and involves bankrupting borrowers (currently 1,542 borrowers) which is a long, drawn-out and costly process. This is likely to be a continual drag on business and has the potential to have second order affects in the communities of these borrowers;
- 15% of the earnings are generated from “Homesafe” i.e. reverse mortgages where BEN takes on “Residential real estate” risk as customers draw down equity in their home. Over the past couple of years, rising real estate prices have assisted BEN’s profitability, however if we are right and the credit cycle is starting to move into the next phases, profitability will be negatively impacted; and
- BEN has a skew of loans towards VIC which has been the place of most concern around over-building.
In terms of what this means for our portfolio positioning, these reference points are sufficient enough for us to maintain minimal exposure to those businesses either operating ‘up the risk curve’ or those companies that are smaller/less diversified across business/lending lines. Our preferred exposure is in large, well-diversified businesses with strong balance sheets, including the major banks, and we are closely monitoring these broader macroeconomic influences.