This story about bank shares begins in a little out-of-the-way country (or outpost on a vacant block at the end of a global cul-de-sac) known as Australia, where residents believe their houses should be the most expensive in the world…
The Australian three-year AA-rated bond yield has been declining since 2012 and mortgage rates have fallen in lock step. Indeed, the correlation between three-year bonds and mortgage rates is high. Unfortunately, those bond rates have been rising recently. This means mortgage rates are about to rise, too.
I would not want to be a leveraged owner of apartments in Sydney or Melbourne – you’re in a bit of bother, as are the banks who, collectively, lent you the money.
Australia’s mortgage debt and household debt-to-GDP ratios are the highest in the world, and with credit-card debt at a record level, consumers – who are also investors – can least afford increases in their mortgage interest rates now.
Of course, as long as highly geared investors keep their jobs, they can raise rents and offset any increase in interest rates on their mortgages. Sadly, however, rents are unlikely to go anywhere but down. A quick detour to Brisbane highlights the issue:
For the nine months to September 2016, just over 5200 apartments were completed within 5 kilometres of the Brisbane CBD. During the same period, owners of apartments 5 kilometres to 15 kilometres from the CBD experienced a doubling of vacancy rates, from 2.3% to 4.7%. Think about that for a moment; just 5200 apartments caused a doubling of vacancy rates. What do you think might happen when the 13,000 apartments now under construction and due for completion in the next 14 months hit the market?
It might not be unreasonable to expect a significant increase in vacancy rates as well as a rise in mortgage interest rates. What is the yield on an apartment with no tenant? Zero! Financial stress anyone? What do landlords with mortgages and no tenant do? Lower rates. What do renters do to their landlord when rents around the corner are dropping? They vacate. What does that landlord do? Lower the rent.
How attractive are investment apartments looking now?
The impact on investor appetite for apartments will be set back by these developments, crimping the growth of every bank’s loan book. On top of that, residential construction is about to hit a wall. In October, apartment approvals dropped by 23 per cent. A drop in approvals is ultimately a drop in construction. That’s another nail in the coffin of bank loan growth.
Without that loan growth, banks need to rely on other means to provide shareholders with increasing earnings. One way they can do that is by reducing their allocation to bad and doubtful debts. Unfortunately, they’ve already been doing that for years and as a result they need to build these provisions back up, which reduces profits. Given the scenario above, it is likely that non-performing loans will climb anyway, forcing them to accelerate the process.
Meanwhile, record credit-card debt limits the ability to grow consumer loans and David Murray’s Financial System Enquiry led to the Australian Prudential Regulation Authority requiring the banks to increase their common tier 1 equity and reduce their mortgage risk weighting ratios, which means more capital and a lower level of leverage on that capital. The end result, of course, is that returns on the banks’ equity will be reduced.
All of the above conspires against the banks being the most attractive investment option for sharemarket participants. Of course, there is a price at which they are extremely attractive for investors with a 15- or 20-year horizon; remember, the population of Australia is growing and eventually it will double, ensuring the banks make a lot more money. But today, bank share prices seem to be reflecting an outlook that does not consider the possibility of disappointment.
This view is not held by all. Indeed, bank share prices reflect the optimism of many. One broker recently wrote: “The last Aussie banks results season once again confirmed no collapse in the housing market, no rampant rise of bad debts, resilient net interest margins and no cuts in dividends or imminent capital raises to rebut the bear thesis, [combined] with attractive valuations and double-digit ROE [return on equity].”
In other words, looking through the rearview mirror, there is no trouble ahead!
After using consensus forecast numbers for 2016 and extrapolating the return on tangible equity, we believe current share prices are factoring in 4.5-5.5 per cent EPS growth into perpetuity from 2017-18, assuming the marginal ROE is in line with the return on tangible equity generated in 2015-16 (with adjustments for ANZ Bank and NAB to reflect a shift in mix away from Asia and divestments, respectively).
So even if we assume a benign regulatory outlook (per the bullish view of many others) with no need to increase capital intensity from current levels, the banks need to grow earnings in line with nominal GDP growth – into perpetuity – to be fair value.
Given the cyclical headwinds to loan book growth, non-interest income growth, the lower than mid-cycle level of bad and doubtful debt provisions that would be extrapolated into perpetuity, this is an optimistic assumption.
If you own shares in the banks and are thinking about where to invest your profits, it would be wise to ask your adviser to reveal to you the small and mid-cap companies that late last year fell as much as 50 per cent while the banks rose. Value investors might rejoice at being able to sell banks at the highs and buy high-quality small growth companies at relative lows.
