Australia’s big four banks have been a winner for their shareholders over the past couple of years.
Their share prices jumped more than 20% each year, on average, for the past two years. Plus, they’re yielding about 6% in dividends too.
However, are these good times over?
In just the past six weeks, CBA has lost 6.8%, NAB is down 7.8%, ANZ 5.7%, and Westpac 7.7%. They’re each down more than 10% from their highs for the year.
On one hand, you could argue that at this price they’re a great buy. But not me. There are reasons to expect further pain in the sector, with the past six weeks being just the tip of the iceberg. Here’s why.
Offshore investors are pulling funds from the local market. They don’t want to be stuck with investments in Aussie dollars as the currency sinks.
The Aussie is already down 7% against the greenback since September, and there’s talk it could drop below US$0.80.
If you’re a foreign investor, any further falls in the Aussie dollar could easily wipe out a 6% dividend yield.
It’s a risk many aren’t willing to take. Plus, they don’t need to. Overseas investments are beginning to look more appealing, with signs pointing to rising interest rates in the US.
Yet the banks’ weakness has not just been due to currency movements. There are a few other issues at play.
Typically, banks perform worse than the market when interest rates are rising — see chart below.
Although the RBA kept rates on hold this month, the market believes that the cash rate will rise. That view is reflected in rising long-bond rates.
This is important because the major banks are sensitive to changes in the long term bond rate. For every 0.01% rise in the 10-year bond rate, the banks’ valuations fall by around 1.5%.
In the first three weeks of September bank share prices dropped sharply as the 10-year bond yield rose by 0.04%. Admittedly, the 10-year bond yield has dropped again going into October.
But taking a longer term view, bond yields will continue to rise.
The US Fed’s bond buying program ends this month and, as above, interest rates in the US are expected to be raised mid-2015. And a further fall in the Aussie dollar will allow the RBA to raise rates to dampen the property market.
The RBA Board used this week’s meeting as an opportunity to reiterate their concerns around lending to property investors:
‘Credit growth is moderate overall, but with a further pick-up in recent months in lending to investors in housing assets. Dwelling prices have continued to rise over recent months.’
It will be interesting to see how this plays out, considering new regulations that have the potential to make a real dent in bank profits. I’m talking specifically about bank capital requirements as regulators worry about the overheated property market.
Westpac is believed to be the most at risk to any action to slow investor lending and house price growth. Loans to investors make up 44% of the bank’s mortgage book. And the loans are concentrated in NSW which is the most at risk property market.
CBA has a large exposure to Australian property too.
NAB and ANZ have the least exposure, as they focus more on business lending.
Regardless, there is concern for all of them about the level of capital the banks hold as a buffer against trouble.
The Australian Prudential Regulatory Authority (APRA) also says that Australian banks simply don’t hold enough. This is despite the Aussie banks holding more than most banks worldwide.
Why do they need to set aside more cash then?
The regulator says that Australian banks are too dependent on foreign funding, operate in a smaller economy, and — as they are deemed ‘too big to fail’ — they should have a larger capital reserves, presumably to protect the taxpayer.
This would not be the first time. Following the GFC the banks were ordered to hold more capital.
The consequence of having to hold higher amount of cash restricts the leverage they have available to make new loans.
For investors, this could very well mean an end to dividend growth.
It can also push the banks into riskier lending to maintain profitability and returns.
It has to be said that, until this point, with the strong property market, losses from these riskier loans and bad debts have been minimal.
But I wonder if this can be expected to continue indefinitely. I suspect at some point the banks’ returns will take a hit and dividend growth will suffer. This isn’t to say that dividends will be cut, but their healthy growth can’t be expected to continue at this rate forever.
For the 2014 financial year, their return on equity for the major banks is expected to be a respectable 15%, but it is expected to trend lower after that.
They certainly face some short to medium term challenges.
I know that yields of 5–6% are tempting. But I suggest waiting for now. In a few months we should have more clarity around their prospects.
Bank prices could very well have further to fall. But if they do fall further you may be able to pick them up at an attractive level — with the downside priced in — and when the time is right.
At the moment there are better investment opportunities than the Aussie banks. You just need to know where to look…and what to look for. In fact, I’ve uncovered an exciting prospect that I’ll be sharing with members of the Albert Park Investors Guild later this month.
For The Daily Reckoning Australia