The Great Bank Bubble of 2013

Welcome to the Great Bank Bubble of 2013 is the title of a UBS research note sent to clients earlier this month. UBS believes that Aussie banks are at bubble valuations considering our lacklustre lending environment. Citibank analysts wholeheartedly disagree, running with the contradictory title: Popping Claims of an Australian Bank Share Price ‘Bubble.’

So who are we to believe?  

Over the past year total shareholder return from the banking sector – dividends plus stock price appreciation – has been stellar across the board.  This includes our two largest regional banks as well as the fabled Big Four.  Here are the numbers, along with some valuation measures, share price and appreciation, and current dividend yield:

 
Moody’s, Standard & Poor’s and Fitch downgraded Aussie banks in early 2012 due to foreign funding worries.  Bank stocks suffered temporarily but quickly recovered in mid-2012.  The following two year chart compares our two biggest banks, CBA and Westpac, against the ASX XAO All Ordinaries Index:

Although it’s not always possible to pinpoint the reason for a change in investor sentiment, the upward movement in share price in mid-2012 does correspond to reports of improvements in the funding mix of the big four.  Here is a recent chart from the RBA showing funding composition:

Another factor that appeals to simple common sense is the RBA rate cuts.  In a world of falling yield from fixed income investments many investors simply turned to income paying equities for higher yield. And banks give good yield.   

The following table summarises the most recent recommendations on the six banks in our table:

 
From a total of 48 recommendations there are 11 at BUY, OVERWEIGHT, or OUTPERFORM; and 11 at SELL, UNDERPERFORM, or UNDERWEIGHT.

Citi states the Bull case for the banks as a matter of “best of breed,” citing strong profitability, resilience, management expertise, and balance sheets. According to Citi, our banks are some of the “lowest risk, highest returning banks in the world.”

UBS doesn’t necessarily disagree but feels the banks are overpriced.  Global central banks have slashed interest rates and printed money – resulting in a bank bubble, UBS argues.  As evidence, UBS analysts cite the 47% rise in bank stocks following the 01 May ECB rate cut along with a pledge to stay with an accommodative monetary policy as long as needed. 

In addition, UBS sees Aussie banks operating in a low growth environment with substantial exposure to housing, funding markets and unemployment risk.

So how sustainable are bank dividends?

Right now our banks are reporting outsized profits and increasing dividends. In fact, CBA expects to deliver a “special dividend” sometime in 2013.  But without growth, dividends can be cut or even eliminated.

The big question is: will banks continue to increase earnings? 

Right now credit growth in both the consumer and commercial sector is lacklustre.  On 15 May CBA released its quarterly trading report.  In the report management characterised credit growth in both the retail and the business segments as “low.”  On the positive side, CBA’s Wealth Management and Insurance business segment saw 4% growth for the quarter due to improving conditions in global share markets.

In its recent Interim earnings release, Westpac also cited challenging market conditions with “subdued lending growth” offset by better performance in wealth management.  

Despite the clamor about stretched valuations, the P/E and P/EG ratios for NAB and ANZ are below the sector averages with Price to Book ratios very close.  Both banks followed the trend with outstanding earnings reports, as did the regional banks, Bendigo and Bank of Qld. 

NAB suffered from a floundering UK operation, which is recovering.  Company management at NAB expressed a cautionary outlook, stating that business and consumer confidence remains low.  

Given the decline in borrowing to fund expansion projects in the mining sector and the subdued appetite for credit, how are these banks producing superior results?  

Cost cutting and productivity enhancements have played a key role; improving wealth management and investment business has also contributed positively.  However, one troubling area for investors is the lowering of bad debt provisions.

Three of the big banks reported lower provisions for bad debts. 

Westpac management is so confident in the decline in bad debts in domestic retail loans that it reduced its provision by 28%.  While CBA raised its bad debt provisions for its business unit by 13%, it cut provisions for bad debts in its largest business unit, Australian retail and home loans, by 31%.  ANZ’s bad debt provisions dropped 13%.  NAB was the exception, perhaps due to its disastrous experience with bad loans in Britain.

Big bank management justifies the reductions due to declines in existing loans going bad across the board.  However, what if their confidence is unjustified?  What if their projections for bad debts are wrong?

While there are few perma-bears around predicting a GFC2, it would be wise to remember the big banks got it wrong in 2007 and the GFC aftermath.  Bad debts at CBA went from $930 million in 2008 to $3 billion in 2009; WBC went from $931 million to $3.2 billion; ANZ went from $1.9 billion to $3.0 billion; and NAB went from $2.7 billion to $3.8 billion and all four cut dividends.  

The big banks survived and thrived because the Australian economy survived and thrived, however it is difficult to conceive of a bank boosting earnings in sluggish economic conditions. 

Interestingly, it’s news out of the US that’s having the biggest impact on the Aussie market lately. On May 13th an article appeared in the Wall Street Journal suggesting that the US Federal Reserve was ready to begin cutting back on its quantitative easing effort in careful steps but earlier than expected.  Rising interest rates in the US are an inevitable outcome of the end of the Fed stimulus and an improving rate of return in the US tarnishes  Australia’s reputation as the “safe haven.”

Few professional investors believed the timing issue and on May 22nd US Federal Reserve Chairman Ben Bernanke testified before the US Congress and gave no indication of an imminent change in monetary policy.  US markets rallied on the news but later in the day the release of the minutes of the latest US Fed Board meeting indicated some members favoured a “tapering off” of Fed bond buying; possibly within a matter of months, sending US markets into a steep decline from which they have not yet recovered.  

UBS and others have observed that the easy money policy around the world is the cause of the rush to equity income investments.  It only stands to reason that a change in that policy could have the reverse effect.  

ASX reaction to speculation surrounding US monetary policy was quick and severe – amounting to the largest one-day decline in two months. Suffering the most were our leading income stocks – Telstra and the big four banks.  The following chart tells the tale for ANZ and NAB:

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2. The Great Bank Bubble of 2013: How sustainable are bank dividends?…

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