The reporting season is under way and given the increased market volatility, we provide further information in addition to our recent market update. With banks occupying a prominent position in most client portfolios we thought it worthwhile focussing on this sector.
Portfolio valuations have been impacted by weakness in financials this year. The sector has been influenced by sentiment associated with global events but appears to be overshooting in our view. We have met with management of Bank of Queensland and attended the CBA result briefing which has provided us with further insights into the sector.
The two key concerns globally include:
1. The potential for bad debt deterioration especially associated with mining and oil and gas exposure.
2. Higher funding costs.
In relation to these two issues we note the following:
1. We expect bad debts to rise for banks in coming years (given they are at a low point).
2. However there are no signs at present in a sharp deterioration. Asset quality remains sound.
3. CBA’s troubled loans continue to fall.
4. Mortgage Insurers are not reporting any significant deterioration in housing delinquencies.
5. Bank of Queensland’s (BOQ) impaired loans and past dues have improved by 2% in the past quarter and they are not seeing any deterioration (at this point).
6. We would expect bad debts to increase from mining exposures. However we suspect global investor’s perceive our banks to be more exposed to this sector than in reality. The major bank’s exposure is around 1.5–2% of total loans. Much of this is investment grade. CBA has fallen circa $40b in market value in the past year yet has only $18b in mining lending. A conservative assumption is 10% of this lending is lost (50% of non investment grade lending). This would allow for a loss of $1.8b compared with $3.7b that CBA holds as provisions for potential problem loans.
7. CBA and BOQ were both upbeat about the economy. While everyone couches their commentary with some caution given the global volatility and uncertainty regarding whether some problem loans will arise, there was also unambiguous commentary regarding the improvements being observed on the ground. CBA stated that “global volatility warrants caution, but overreaction also a threat”. Both banks noted the transition the domestic economy is making from being resource dependent with tourism and other export sectors picking up the slack. While risks remain the economy appears to be handling the downturn in mining capex surprisingly well.
8. Higher funding costs will have a small impact on profits by reducing margins however we would expect the banks will seek to manage this impact. We have already seen some price increases on mortgages and more recently business lending.
Bad debts are at a low point in the cycle and will increase from here, however the market is anticipating a significant deterioration of which there is no evidence to support. Valuations on the banks look attractive.
- PE’s look attractive relative to the market at 10.8x—a 25% discount.
- Dividend yield grossed up is trading at a large premium to cash rates. We allow for a 10% haircut to dividends but the yield is still 8.6% (grossed up).
- Historically when the banks have moved sharply negative on a one year basis it has proven an attractive entry point. See the WBC momentum chart below.
- Earnings outlook remains solid. * The banks have been heavily impacted by regional selling / shorting which we see as a contrary indicator.
- Global bank peers have been sold off and are generally trading at lower PE’s than domestic banks (albeit this is justified by lower capital levels, lower returns and greater historic volatility).
- While money is exiting the Asian region, pressure will remain on domestic financials.
- There is the potential for lumpy problem loans to emerge in the mining space which can cause negative sentiment (particularly for ANZ).
- There is some potential for dividends to be reduced (but suspect the banks will be reluctant to take this course and allow profit growth to chip away at the payout ratio).
Please do not hesitate to contact me should you wish to discuss anything in greater detail.