I’m writing today’s Daily Reckoning early, before the market opens. But I notice ANZ Bank [ASX:ANZ] just announced a profit shocker, with cash profit down 24% year-on-year. I’ll bring you the details on Thursday.
ANZ’s result comes hot on the heels of yesterday’s half-yearly profits from Westpac Bank [ASX:WBC]. Investors weren’t impressed. The stock finished down 3.6% for the day, after being down nearly 5% at one point.
The details of the result (which I’ll get to in a moment) sent a wave of panic through the banking sector. While all the focus will be on the budget over the next few days, Westpac’s results (and the other banks to follow) will have a greater effect on the market.
So what was it that the market didn’t like? After all, earnings rose 3% over the year, right?
As always…and especially when it comes to complex companies like the banks…the devil is in the detail.
Here’s a tip though. If you do own the banks and take an interest in their results, I’ve got a great analytical shortcut for you.
If you want to know whether the results were ‘good’ or ‘bad’, simply check the change in the return on equity (ROE). In Westpac’s case, the year-on-year ROE declined 166 basis points, to 14.2%.
That tells you Westpac is becoming less profitable. Profits are one thing, but what the market REALLY cares about is profitability. That is, how much profit a company generates on a given amount of shareholder equity. This is why I always check the change in ROE. The share price nearly always tracks it.
In the case of Westpac, or the banks in general, their ROE has been high for years. When I say high I mean much higher than the global banking average. That’s partly because of Australian household’s insatiable appetite for debt, which the banks facilitate…and partly because the Big Four banks employ high levels of leverage.
But, now, both of those tailwinds are becoming headwinds. Yesterday’s results indicate that the former powerhouse division, Consumer Banking, is slowing down. This is basically the home loan division.
In the 12 months to 31 March, Consumer Banking grew cash earnings by 16%. But most of that growth came in the first half. Growth in the six months to 31 March was just 5%.
That tells you demand for mortgages is beginning to slow.
Also, the banking regulator, APRA, is belatedly getting the banks to lower their leverage by telling them to hold more ‘regulatory capital’ against their assets. Regulatory capital is basically shareholder equity, so banks have had to raise more equity over the past year, which means more shares on issue.
As a result, earnings per share actually FELL 2% in the half.
Notably, the impairment charge (bad loan write-off) doubled compared to the first half of 2015, which also impacted profits.
In other words, all indications are that the halcyon days are well and truly over for the banks. Those signs have been around for a while now, but this reporting period will confirm it. (ANZ did just that this morning.)
Westpac’s chart certainly confirms it. As you can see, over the past 12 months the share price has been in a slow but steady downtrend. A break below $28 will signal another painful leg down for the share price.
The only thing that will give Westpac (and the banks in general) a boost is another, good old interest rate cut.
The RBA meets today to deliberate on that very issue. I doubt the RBA will cut rates today, but last week’s soft inflation data has changed the market’s view on the issue.
This is insane, but it goes to show the twisted thinking of conventional economics. Here’s a gist of it from the Financial Review:
‘The Reserve Bank of Australia faces one of its toughest decisions in years, backed into a corner between implementing an unprecedented budget-day interest rate cut to offset falling prices, or holding rates steady to avoid hurting retirement savers and stoking fresh doubts about the strength of the economy.
‘Former board member Warwick McKibbin dropped his emphatic opposition to another rate cut because of soft inflation data and issued an unusual recommendation, that the Reserve Bank would be equally right if it lowered the cash rate to 1.75 per cent or held steady at 2 per cent.’
Let’s get this straight. Because consumer prices aren’t rising as fast as they ‘should’ be, it apparently represents a tightening of monetary policy. That’s because nominal interest rates, minus inflation, equals the real interest rate.
And because last week’s inflation number came in weaker than expected, conventional economists see an increase in real interest rates, believing we need another interest rate cut to lower real interest rates again.
But let’s think about this…
Cutting nominal interest rates pushes asset prices up. In Australia, it’s pushed the price of the only asset that really counts — property — up to such high levels that new entrants into the market need to take on large amounts of debt.
This means debt servicing costs are very high, which means a high proportion of incomes must go towards supporting the debt. That leaves less money to spend in other parts of the economy. Less money equals weaker demand.
This weaker demand is behind the soft consumer price inflation numbers.
And the conventional economic solution? Cut interest rates again! This will put more upward pressure on asset prices, increasing the need for more debt. And so it keeps going around and around…
The reliance on falling interest rates and ever increasing debt to maintain short term economic growth is a clear sign of a broken model. Yet we keep persisting!
It really is extraordinary.
But do we deserve any better than what our officials and politicians serve up? While we continue to believe the lies, accept the arguments, and demand so little…no, we don’t.
As the saying goes, you reap what you sow…
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