Budgeting for tax, risk and earnings
29 May 2017
By Shadforth Financial Group
Last July, banks had relatively low valuations. They didn’t necessarily need to raise capital directly and were a good alternative to the expensive yield plays.
Subsequently, the banks have performed strongly, outperforming the index by 12 per cent at the end of April (Chart 1). Post February updates, valuations had become stretched after the rally in their share prices.
Half year results showed a slowing of bank fundamentals. Despite the fall in share prices, the sector now appears to be facing further regulatory, economic and fundamental headwinds and the stocks look relatively fully priced.
Chart 1: Bank stock performance
Source: IOOF Research, Bloomberg
Where are we now?
Valuation uplift for the banks has been supported by the slowly improving economy, increased credit and loan growth (Chart 2), solid dividend yields and the steepening of the yield curve. Stock prices have reflected the sentiment.
Chart 2: Credit* ratio to nominal GDP
*Not adjusted for breaks
Sources: ABS; APRA; RBA
Over the last year, Australia has witnessed strong housing price growth, especially in the eastern states, increased credit, increasing debt to GDP ratios and an acceleration of debt to income levels (Chart 3). The housing boom has been driven by extremely low interest rates. Although housing remains expensive, affordability has been supported by the continued low cost of debt (or interest expense as a percentage of disposable income).
Chart 3: Household finances (per cent of household disposable income*)
*Disposable income is after tax and before the deduction of interest payments
**Excludes unincorporated enterprises
Sources: ABS; RBA
The banks performed strongly for decades and have continued to perform more recently despite margin pressure, increasing funding costs and capital requirements. They have maintained profitability and increased earnings per share through increased loan growth, cost cutting and passing on increased funding costs through higher rates. However the environment appears set for a change thanks to competition and shifting winds. We believe the banking sector is moving from strong tailwinds into dead air space with potential headwinds.
The changing banking dynamic
The big four banks used to display subtle differentiators. National Australia Bank (NAB) had a UK business, the Australia and New Zealand Banking Group Limited (ANZ) had an Asian strategy and the Commonwealth Bank of Australia (CBA) and Westpac Banking Corporation (WBC) were domestically focused on home lending. With NAB divesting the UK and ANZ retreating from Asia, the big four increasingly look the same with much subtler differences. NAB and ANZ remain focussed on business banking, while WBC and CBA are more exposed to home loans. All currently have some wealth management with the exception of ANZ. Going forward, the big four will have an increasing focus on the domestic market, leading to bigger competition and tighter margins. We believe the banks will have to become more focussed on costs, while we expect return on equity to continue to drift lower.
Tailwinds becoming headwinds
The banks have benefitted from strong growth of their loan books as the property market has strengthened substantially over the last few years. This is expected to ease through APRA intervention and banks increasing rates out of cycle. Furthermore, even if the RBA drops rates in the short term, rates will go up over the longer term, putting the brakes on home prices, loan growth and potentially the economy. Given Australian banks have loan books that are highly exposed to mortgages, the housing cycle is critical to the long term success of the banks. The stability of the sector is paramount for Australia.
The Federal Government announced that a 0.06 per cent levy will be introduced to banks with liabilities greater than $100 billion, impacting the big four and Macquarie. While the banking tax is relatively small in absolute terms, it will have a negative impact of between two and five per cent on earnings across the banks.
The Government is targeting at least $1.5bn of revenue per year. We believe this demonstrates that they will more than likely increase the levy above 0.06 per cent if they don’t realise the targeted revenue.
We believe the banks will most likely try pass this tax on in the form of higher interest rates or lower deposit rates, not as a ‘one off’ change, thereby avoiding the wrath of Government. Instead, it will be eased into the system over time.
We are of the view, however, that the Government will be focussed on preventing the pass through of increased rates, evidenced by the fact that they have introduced a residential mortgage pricing inquiry until 30 June 2018 by the Australian Competition and Consumer Commission (ACCC). Banks will be required to explain changes or proposed changes to residential mortgage pricing, including changes to fees, charges or interest rates. This will aid the efforts by the Government and APRA to provide a more level playing field for smaller banks and other competitors and is what we believe to be appropriate ‘payback’ for the guarantees the Government has been providing.
The regional banks are not subject to this levy and may present an alternative to the big four for both customers and investors. The regionals may become ever-so-slightly more competitive if the big four try to pass on the levy to customers, while at the same time not being subject to the levy. This could boost their relative profitability, though only marginally.
The bigger concern perspective is the Pandora’s box the coalition has opened. In the UK, the rate of their similar levy has been extraordinarily unstable, with the UK government increasing it nine times as it tried to hit its revenue target of £2.5 billion a year. This levy is unlikely a one-off given its populist appeal, however we would be of the opinion that if a Labor government came to power, they would probably increase this substantially.
Bad debt cycle
The banks have been able to manage the debt cycle well, with bad debts remaining low with minimal impairments. The banks have seen some softness in Queensland and Western Australia as the economies struggled with low wage growth, elevated unemployment and falling property prices despite some relief after commodity price stabilisation. However we believe the environment will remain tough given lower investment by the mining industry, softer mining economies and weaker labour markets expected.
It is clear that mortgage stress and increasing bad debts remain a possibility going forward. This was highlighted by the CEO of Genworth (Lenders Mortgage Insurance), who said, ‘“Wage growth is also subdued, especially due to the transition away from mining-led activity and low actual and expected inflation. These labour market dynamics are increasing the instance of mortgage stress in certain regional economies and we expect these trends to drive elevated mortgage delinquencies in these regions in 2017.’
Despite the low bad debt cycle, the risk remains to the upside given the potential increase in interest rates, sluggish economy, softer retail environment and leveraged consumer.
Lending standards and requirements
APRA have looked to tighten lending standards, especially around interest-only loans, placing pressure on banks to slow the property investment market through tighter lending standards and limited interest-only loans (less than 30 per cent of new mortgages can be interest only, where the previous peak was 45 per cent). APRA expects authorised deposit-taking institutions to comfortably remain below the previously advised 10 per cent benchmark for growth in lending. The net impact will be lower home loan growth and slower investment loan growth negatively impacting earnings in the short term but ultimately better credit standards in the long term.
The major positive from the bank results was the solid capital position of all the banks in general coming close to or above 10 per cnet (Tier 1 Capital position), driven by an acceleration in risk-weighted asset (RWA) run-off. This is especially pleasing ahead of final determination of the Australian Prudential Regulation Authority’s (APRA) ‘unquestionably strong’ framework later this year and Basel 4. Furthermore, the banks are unlikely to need to raise capital directly but we believe this will occur through the sale of assets, dividend reinvestment plans and flat dividend growth.
Despite an environment that should have benefitted the consumer (low interest rates, low oil prices and stronger business conditions), the consumer has struggled under low wage growth and overburdened balance sheets. Savings rates have been elevated since the GFC and the nature of consumption has also changed, shifting to experiences (eating out, etc) rather than goods. We have already seen retail sales slow over the past quarter and consumers will be under increased stress as banks look to reprice mortgage books higher (due to increasing funding costs and tax increase). With APRA forcing people to move from interest-only loans to interest plus capital, the net result is lower disposable income further pressuring credit growth, the economy and bank valuations.
Chart 4: Deteriorating wage growth
No changes are expected to hybrid pricing based on the introduced bank levy. While the introduced levy is negative for earnings, we foresee no changes to the banks credit rating, with APRA reiterating a preference for banks to be unquestionably strong. The ability for the big four to meet their obligations with regards to AT1 securities is unchanged. There may be some changes to forthcoming AT1 issuance based on exactly what liabilities are captured by the bank levy. The current proposal is for the levy not to apply to AT1, which may make it a slightly more attractive option for bank issuers going forward. Investors might ‘hide’ in hybrids as they try to figure out the full implications and long-term effect of the government opening Pandora’s Box.
The banks do not look excessively expensive relative to history or the S&P/ASX 200. When the solid dividend yield and low level of bad and doubtful debts are factored in, the banks appear to be fair value to slightly expensive.
Chart 5: Banks PE ratio
However, given the risks highlighted around the economy, the consumer and asset prices, bad and doubtful debts will likely creep up, banks will realise slower consumer and credit growth, slower home loan growth and increased domestic competition will pressure margins.
With those factors and the bank levy and continued regulation and funding pressure, headwinds are starting to build. While we don’t believe the banking sector is dire nor do we believe the earnings will go backwards, we are of the opinion that banks will most likely not outperform the index and possibly even underperform. We believe opportunities may be found in regional banks not impacted by the tax (but still subject to the other risks).