It seemed but a few short moments ago the world marveled at the health of the Australian economy, and the strength and resilience of our rock solid financial system led by the Big Four Banks. Having dodged the worst of the GFC, we were the envy of the world. Foreign investors poured into Aussie debt instruments, driving up the value of the dollar.
However just recently the rest of the world has woken up to what we have known for a long time: our economy has two speeds, and the high speed resources sector is shifting into a lower gear as China slows.
But while the materials sector has retreated significantly over the last six months, the financial sector was gone from strength to strength. Here is a six month price chart comparing BHP Billiton (BHP) to the Commonwealth Bank of Australia (CBA).
The trouble with our two-speed economy is that the gears are interlinked. Our dependence on mining, and the mining sector’s anticipated downturn, will adversely impact other sectors, including our banks. It’s just a matter of time.
Bearishness towards banks
Recent changes in our economic outlook will make it highly unlikely the big banks can maintain the level of profitability seen in recent years:
1. Mining Slowdown
2. Property Market Fallout
3. Low Doc Loans Exposure
US investment firm Qineqt is advising its clients to short Aussie banks, citing Westpac, ANZ and CBA. The investment firm argues that the best way to play the Australian mining slowdown is to short banks.
A point often overlooked is that Aussie banks are huge. By market cap, the ASX financial sector is larger than all of the Eurozone’s publicly traded financial institutions. However, our GDP is dwarfed by that of the Eurozone.
Our glory days have bloated the big banks to a risky level that appears to be largely overlooked in favor of the move obvious concerns over mining and the property market. The following chart says it all:
Since the GFC, mining companies in Australia have upped their gearing to finance new projects – and the big four banks are exposed to these new debts; clearly, this increased reliance on the mining sector for interest income becomes problematic when the mining sector slows.
An event that sent a tremour across the market was the price of iron ore falling below US$100 per tonne. The second was BHP’s announcement that it was shelving expansion plans for the Olympic Dam project. When our biggest miners begin to shelve expansion plans and staff, it sends a message to the market that consumption and business activity will be adversely affected.
At the heart of the slowdown is diminishing Chinese demand for iron ore. While some stubbornly maintain that demand is weak due to inventory oversupply, the fact remains that price declines make many mining projects unprofitable. Iron ore is currently 50% lower from its high of around US$191 in 2011.
August 2012 economic indicators for Chinese growth added to the gloom and doom. The HSBC Purchasing Managers Index (PMI), which has been below the key 50 level for ten months, fell to 47.6, the worst reading since 2009. China’s official National Bureau of Statistics PMI fell more than expected to a reading of 49.2. Industrial production came in at 8.9%, the worst reading in over three years. Finally, the all important growth in fixed asset investment fell short of expectations of 20.4%, coming in at 20.2%.
The biggest problem this poses for the big four banks is credit expansion and the cost of funding credit.
Understanding how banks make money can be confusing; to the layperson it would seem that bank deposits are considered assets and bank loans are liabilities. In truth, the opposite is true. Bank deposits have to be repaid with interest, which makes them liabilities.
Bank depositors lend their money to the bank and these deposits are used to make loans that are repaid with interest over time. Net interest margin in banking is the percentage difference between the interest the bank pays its depositors (lenders) and the interest it collects from its borrowers (loan recipients.)
Unlike the US banking practice of selling loans – which are then used as investment vehicles – Aussie banks hold the loans on their books. Often, deposits are not enough to fund the loans – hence the banks rely on asset funding through debt instruments, especially from foreign investors.
Despite credit downgrades for overreliance on foreign funding sources, it appears the big four still get around 40% of the cash they need to make loans from foreign investors.
Foreign investors are attracted to Aussie debt instruments because of our high interest rates – currently the best in the world. Our interest rates are high because our GDP has remained strong courtesy of the mining boom. But what happens when the mining sector slows and our GDP contracts? If foreign investors pull out of Aussie debt, it threatens the asset base of the big banks.
Massive inflows of foreign investment into Aussie government bonds are also inflating the Aussie dollar. Normally, the value of a country’s currency moves with the terms of trade (the terms of trade is a comparison of a country’s export and import prices. Rising export prices improve the terms of trade while falling export prices lower the terms of trade.)
High commodity prices for our exports has driven the Aussie dollar upward. Below is a chart showing the relationship between our terms of trade and the value of the Aussie dollar:
Source: TD Securities
Strong demand for our commodities from Asia, and our relatively healthy economy has made the Aussie dollar an attractive bet against instability in Europe and the US.
But lately, the Aussie has remained strong while our terms of trade has declined? RBA official Guy Debelle pinpoints the massive inflow of foreign investment into Aussie government bonds. This is borne out by a chart from the Australian Office of Financial Management:
Massive foreign inflows result from the belief that our debt markets yield the highest possible return for the lowest risk. However the combination of a slowdown in the property market and the mining sector increase the level of risk that foreign investors take on when investing in Australia.
Last week, US equity markets closed at multi-year highs on the strength of the the ECB bond buying program and an anticipated larger than expected increase in job growth in the US.
If conditions in Europe and the US improve, how long will it take foreign investors to begin to look elsewhere? Couple that with continued drops in commodity prices and RBA interest rate cuts and you have a recipe for a collapse of the Aussie dollar.
Property Markets and Low Doc Loans
The banking sector is looking down the barrel of a housing slowdown. Housing credit growth increased 4.9% in the year to July – the weakest annual growth rate in 36 years. August figures just released by the Australian Bureau of Statistics (ABS) showed a 1% decline in approved home loans.
Profits at the big four are driven by home mortgages and many property pundits are calling the market lower.
Investec Asset Management strategist Michael Power sees prices declining an additional 12 to 15 per cent over the next 18 months. Such forecasts are keeping potential homebuyers at bay.
And as if the prospect of diminishing credit expansion were not enough, we now have reason to believe the big four banks may be at risk from low-doc and no-doc loans.
According to the Mortgage and Finance Association of Australia (MFAA), a Senate inquiry is underway into allegations that borrowers were forced into low doc loans by lenders and brokers. The Reserve Bank of Australia reckons there’s around $50 billion worth of low-doc loans, which represents about 5 per cent of bank balance sheets.
Banks post record profits
While the outlook does appear grim, the performance of the big four banks to date has been nothing short of exceptional. Three of the four recently reported earnings, with a full year report from CBA and quarterly reports from ANZ and NAB. The following table provides some valuation ratios, dividend yield, and share price ranges and year over year percentage change for the big four:
52 Wk Hi
52 Wk Lo
Year over Year % Change
Commonwealth Bank Australia
Australia New Zealand Bank
National Australia Bank
All banks are trading close to 52-week highs and at premium book value multiples. Only recently has bearishness towards the banking sector seen a slight pullback in price.
National Australia Bank’s (NAB) operations in the UK have suffered, yet their quarterly unaudited results for cash earnings showed a respectable $1.4 billion. Management claims the bank is on track to yield a record-setting profit for the full year profit coming in at approximately $5.5 billion.
NAB’s larger rival, Australia and New Zealand Bank (ANZ) reported a 5.5% year over year profit increase with a result for the period of $4.5 billion. ANZ has expanded operations in China and the strategy has paid off while NAB’s United Kingdom venture did not. ANZ now derives more than 20% of total earnings from Asia.
Like the other members of the big four club, these two banks rely heavily on consumer loans but are looking to expand their penetration into the business sector. With a greater focus on the Australian market, both WBC and CBA have been rewarded from the stream of consumers looking to park their money into bank deposit accounts.
Commonwealth Bank of Australia (CBA) reported $7.1 billion Net Profit after Tax (NPAT), a year over year increase of 4%. Earnings per share (EPS) increased 2% to $4.49 and dividends increased 4% to $3.34 per share, a record payout.
While it’s easy to get carried away by the sheer size of bank profits this reporting season, stock pickers need remember that share prices are based on future earnings, and not on profits reaped in the past.
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