Clime is a value-based absolute return investor. Unlike traditional approaches seeking to outperform index benchmarks, Clime’s approach focuses on our customers and their need to increase the purchasing power of their capital. This also involves providing investors with security in their investment journey.
Australia’s major banks are included within Clime’s large-cap sub-portfolio allocation and their main role is to provide solid franked dividends. We forecast flat dividends in 2017 as banks weigh flat earnings against strong capital positions, surplus franking credits and investor pressure not to cut dividends. Share prices should level out when dividend yields rise to 6 per cent.
Underlying earnings growth faster than low single digit in 2017 will be difficult for banks to achieve. This is due to operating cost pressures, record consumer indebtedness, patchy consumer and business confidence, weak investment in the economy, competition, subdued growth in wages and part-time as opposed to full-time job creation.
Also, the political landscape is hostile to banks, with scrutiny of interest margins and profitability. Shareholders are increasingly questioning bank CEO remuneration and Commonwealth Bank received a first strike against its remuneration report at the 2016 Annual General Meeting.
An industry-funded review of bank sales incentives schemes has already pushed at least one major bank to reduce the contribution of sales volumes to branch staff bonuses, with customer satisfaction elevated. This could incrementally dampen sales.
Despite these headwinds, we forecast that ANZ, National Australia Bank and Westpac, bought at current prices, should deliver solid returns that include dividends over 2017. This is because the equity market pull back of recent weeks has increased dividend yields and generated reasonable value. CBA is forecast to deliver a net nil return after dividends because the stock has become too expensive.
This table presents our forecast total shareholder returns, in descending order, for the major banks in 2017:

The opportunity in banks at current prices is an example of a pattern that should repeat in 2017: upgrades to US and world growth forecasts provide underlying support to equity markets and corrections due to US (Trump) policy uncertainty/disappointment create attractive entry points by generating value in individual stocks. The lack of growth in bank earnings means investors will only earn adequate capital returns if they buy at double-digit discounts to value. This makes robust and rational bank valuations an essential part of the investor’s toolkit in 2017.
Dividends are unlikely to be cut given strong regulatory capital positions, organic capital generation due to slow lending growth, and a likely phase-in period for any higher capital requirements from the Basel IV process and Australian Prudential Regulation Authority’s response. There is also enormous pressure on bank boards not to cut dividends given the dependence on banks of a great many investors for income. Three of the four majors have dividend payout ratios above board targets but banks will prefer to work their dividend reinvestment plans harder before disappointing shareholders by reducing dividends per share.
For the more active and disciplined investor there could be trading opportunities in banks around the above valuations. After the sharp rally of November and December 2016 we exited CBA above our valuation and also reduced our overweight positions in ANZ and NAB above $30 as a hedge against the policy uncertainty and lack of stimulus detail we now see from Trump. With the subsequent correction in bank stocks we are now preparing to buy back in again.
Bad and doubtful debts expense is unlikely to grow materially this year. Last year’s increase in underlying impairments and stressed exposures was in the New Zealand dairy industry and towns in Australian mining regions. The recovery in dairy and commodity prices should see this deterioration unwind through 2017 after a final uptick in stressed dairy exposures due to delays in receiving higher payments from milk processors.
So far the falls in inner-city unit prices and longer delays to settlement have had no discernible effect on major bank mortgage impairments. Since mid-2015 banks have substantially reduced their exposure to this segment and we think the inner-city downturn will turn out to be no more than an irritation for the majors.
More broadly, general indexes of house prices outside mining states continue to rise, unemployment remains moderate, average loan-to-valuation ratios in bank lending books are moderate, interest paid as a proportion of household disposable income has fallen sharply with interest rates, and there are no signs yet that most mortgage borrowers are struggling to meet their repayments. Credit quality in the small to medium business sector also remains healthy due to economic growth and low interest rates. In 2017 there will be pockets of stress rather than widespread loan impairments.
In response to higher wholesale funding costs as world interest rates trend higher, banks are currently testing the tolerance of borrowers, politicians and the public to out-of-cycle (without the justification of official interest rate increases by the Reserve Bank) rate rises by hiking fixed mortgage rates for owner-occupiers and fixed plus variable rates for investors. We detect no negative reactions by stakeholders yet, so banks will be tempted to lift the more politically sensitive standard variable rates by less than a quarter-point RBA rate hike. Because variable-rate mortgages are the largest component of bank mortgage books, sustained rate rises here would justify consensus earnings upgrades even if they only offset higher wholesale funding costs. Deposit funding costs have abated now banks have reached their regulatory stable funding targets. We expect world interest rates to trend higher in 2017 – a favourable environment for banks to manage their interest margins.
We forecast property price indexes in the key markets of Sydney and Melbourne to rise again in 2017, though at a more sedate pace as the current exuberance in those markets dissipates with perceptions interest rates have bottomed. The upside risks to mortgage impairments lie more in 2018 as 2017’s mortgage rate rises start to weigh on Australia’s extremely indebted household sector. Our base case is no material rise in general mortgage impairments as long as unemployment stays below 7% and interest rate rises are small and gradual. Should unemployment deteriorate sharply and/or interest rates rise sharply, banks do not currently have sufficient collective provisioning to cover the rise in bad debts that would result. Indeed, some would say banks have used the recent historically benign conditions in loan quality to bolster their earnings by reducing collective provisioning.
The most likely source of any disappointment in bank earnings this year is upside surprises in operating costs. Banks are experiencing steady cost inflation from higher regulatory and compliance costs and also the need to upgrade obsolete technology systems. The risk is banks are unable to offset these with cost savings elsewhere.
While we enter 2017 with many uncertainties, we remain confident of being able to deliver attractive long-term results to clients. We temper our caution with a disciplined valuation methodology driven by a realistic view of what an appropriate investment return should be. On this basis, and with the comfort of holding a cash cushion within portfolios, we reaffirm our positive outlook for portfolios and particularly for companies with robust profitability.
In 2017, as previously, most of the ASX’s best growth opportunities will be found outside large caps. Nevertheless, banks continue to have a role in ASX portfolios this year. Investors should use macro-driven selloffs this year to prudently increase their positions but be constantly aware of valuations in managing risk across their portfolios.