The Great Complacency

Australia’s major banks have continued to defy expectations, and remain on track to deliver stronger returns than the broader market for the fourth consecutive calendar year, although the outperformance has narrowed somewhat this year.

In recent years, earnings expansion rather than multiple expansion has underpinned bank sector outperformance.  Analysts have lifted their EPS forecasts by more than 15% since the start of 2013, at a time when resource sector forecast earnings have continued to be downgraded against the backdrop of falling commodity prices (see chart).  But the bank upgrades have slowed in recent months.

Despite widespread concerns in the investment community that the yield trade has run its course, I believe that the bank sector will continue to offer outperformance in the near term for a number of reasons: loan loss provisioning is likely to under-shoot analysts’ expectations, the sector valuation is not stretched, and the dividend payout ratio is in the historical range.

But over the medium term, investors should be cautious on the sector due to the great complacency; the sector’s index weight remains close to an historical high of 30% and Australia’s banking system remains undercapitalised, and will remain so even if the government embraces the Murray Inquiry’s interim recommendations for a modest rise in capital ratios.

No mean reversion in BDD charges while corporate capital structures remain conservative

Ongoing declines in cost to income ratios and bad & doubtful debt charges have helped to boost bank sector EPS forecasts over the past two years.  Cost to income ratios are low by global standards, which have benefited from a focus on mortgage lending, while loan loss provisioning has dropped to below 0.25% of total loans, which is below historical trends.  But bad & doubtful debts have remained below the long term median and mean estimates for extended periods before (see chart).

The already low level of BDD charges is unlikely to give bank sector earnings the same tailwind as in recent years.  But as long as animal spirits remain dormant and CFOs are still reluctant to lift gearing, provisioning should continue to surprise on the downside, particularly for those analysts projecting BDD charges to mean revert over the next three years.

Bank valuations don’t look stretched

The sector is trading on 12.4 x 12mth forecast earnings, which represents a 10% discount to the broader market (13.8x), in line with the historical norms (see chart).

The sector’s payout ratio remains in the normal range

Despite rapid growth of dividends in recent years, the bank sector’s payout ratio has remained below 75% for a while now.  Indeed, analysts’ upgrades to EPS forecasts over the past two years have outstripped their DPS projections (see chart).

Historically high index weight

A long run perspective shows that the bank sector’s index weight remains close to a record high of 30% (see chart).  This has been a poor contrarian forward looking indicator for performance in recent times; the sector’s index weight has been at, or close to a record high since mid-2012.  Nonetheless, the high index weight which contributes to the high concentration of Australia’s stock market, points to a growing complacency and longer term tail risk.

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Australia's banking system to remain under-capitalised

The Murray inquiry’s draft report helped to dispel the notion that Australia’s major banks are well capitalised by global standards.  Nonetheless, the preferred capital ratio used in the draft report points to only a modest rise in the sector’s capital requirement.  Based on the leverage ratio – which replaces risk weighted assets with total assets in the denominator – Australia’s major banks remain 200 basis points below the global median (see chart).

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The bank sector’s razor thin loss absorbing capital means that there is a growing risk that they might not be able to withstand even a small decline in the value of their loans, and that fire sales of assets will have knock on and contagion effects on other banks and financial institutions.  The associated crisis of confidence will expose the great complacency. 

The near-term risks are low because corporate sector balance sheets remain in excellent shape.  But investors should look to move underweight the banks when there is growing evidence that animal spirits are reviving, reflected in a sustained pick-up in growth of business credit.  This however remains way off, given that the Reserve Bank continues to under-estimate the power of monetary policy to boost entrepreneurial risk taking.

NAB remains the laggard on profitability

At the stock level, NAB remains the laggard on profitability.  The stock’s forecast profitability remains 10% below the pre-GFC peak, while each of the other banks have had their EPS estimates upgraded over this time by no less than 10% (see chart). 

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NAB’s poor track record on profitability appears to reflect slow growth in its net asset base compared to the other banks.  In the past decade, it has expanded its book value per share by only 20% (see chart).

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