The banks and supermarket retailers dominated financial market developments in Australia over the past week. Investors were disappointed by full year results from ANZ and NAB, with the stocks falling by 6-7% over the week, well below the 2% weekly decline in the ASX200. Woolworths was down 13% following another profit warning, while Wesfarmers was part of the collateral damage of what appears to be a renewed supermarket price war, with owner of Coles supermarkets falling 5% for the week.
Banks – Rebasing dividend expectations
Good news from NAB that it had sold an 80% stake in its life insurance business to Nippon Life was offset by further deterioration in the business banking net interest margin, an acknowledgement that competition in business lending remains intense and a flat dividend for the full year. ANZ’s dividend was up only 2% for the full year.
Despite marginal improvements in bad & doubtful debts for the sector as a whole, bank earnings are no longer benefiting from such a big free kick as in recent years. Combined with dormant animal spirits in the corporate sector and anaemic growth in business lending, analysts have scaled back expectations of dividends this year after rapid growth for five years (see chart).
Lift in capital requirements leads to higher equity, not higher costs
The major banks’ desire to halt their deteriorating net interest margins does a better job of explaining the recent lift to mortgage lending rates, than APRA’s recommended lift in capital requirements (see chart). It remains disappointing that there is a widely held view in the investment community that the lift in mortgage lending rates was a rational response to higher costs of capital. An increase in the amount of loss absorbing capital or equity finance used to fund its assets represents a shift in capital structure, not an increase in costs. The lift in capital requirements affects the balance sheet– specifically a change in a bank’s liability mix – not the income statement.
Mr Wayne Byers, the head of APRA, was right to testify to Parliament recently that the increased capital requirements should be associated with lower expected returns from the sector. By making banks safer and less risky, the Miller-Modigliani Irrelevance Theorem says that more equity capital should reduce banks’ expected cost of equity.
Woolworths – Rebasing expectations
New Woolworths Chairman, Mr Gordon Cairn, swept the slate clean by delivering NPAT guidance for the first half of 2016 that was up to 35% lower than the 1H15 result. Since Evidente suggested in early June that the risk-reward proposition had become more compelling, analysts have continued to downgrade the stock’s growth prospects, as the company’s supermarket margins come under pressure from Coles and Aldi, and BIG W and Masters continue to perform poorly.
Investors are likely to reward WOW if it divests these businesses in due course, which will leave management to focus on boosting sales and profitability of its supermarket division. Unlike Tesco in previous years which suffered a series of severe downgrades, Woolworths is not priced for perfection, and remains cheap across earnings and book multiples. This should help to limit the downside from current levels and probably explains why the price fall in the past week was significantly smaller than the downgrade in guidance.
Supermarket price war augers well for low inflation and lower interest rates
The profit warning was also associated with a sharp fall in Wesfarmers shares, presumably as investors lift the likelihood of a renewed price war amongst the supermarket retailers. It is another clear signal that growth in consumer demand is struggling to keep pace with the ability for the supermarket chains to grow supply. Evidente remains of the view that the RBA should respond to the broader shortfall in aggregate demand in the economy by delivering more monetary stimulus at the Board meeting on Melbourne Cup Day. At present, interbank futures are assigning a probability of a rate cut in November at 50%.