Market Update

Friday, September 23 2011

Markets were soft on global growth concerns. This was not based on economic news but rather the reaction to statements by the World Bank. Recent statements by the RBA however remained upbeat and highlighted the resilience of the Australian economy.  Nonetheless the macro concerns continue to weigh on our market.  As a consequence we assess the bank sector below in light of our position in that sector and in light of its weakness in the face of global macro concerns. We have a look at the potential impact on the major banks of a step down in the economic environment and the changes the banks have made to their balance sheets in recent years.

Bank share prices are cheap with dividend yields (grossed up) of 11.5-12%.

They appear to be factoring in a major deterioration in earnings.

We highlight the three possible risk areas below.

 1. Bad debts deteriorating.

Australian unemployment is around 5.3% compared to an 11% rate in the early 90’s and interest rates are at 4.75% compared to 18%.  Furthermore the RBA has the flexibility to lower rates (which we expect over the next quarter). Over the next year a major pick up in infrastructure spending is expected. There is around $80b in major capital projects expected (not all of this will be spent) and Queensland will spend $5b in flood recovery. Furthermore the Australian economy was impacted last year by the floods particularly lower coal production. There will be a rebound in this regard. Slower European and US growth will have some impact on growth rates but of course the Chinese growth rate is more important. Chinese growth rates could slow but they continue to have significant policy flexibility.

If we allowed for bad debts for mortgages and small business to deteriorate to a similar rate as the early 90’s (corporate bad debts have peaked and are declining) then a decline in earnings would be 10-14%. Stocks would still trade on single digit PE’s.

2. Funding has become more difficult for banks but Australian banks are much less reliant on offshore funding because deposits are outstripping lending at present.

The risk of the European issue is funding would close for a period.  We note that the Australian banks continued to access funding during the GFC. However they now have much lower funding requirements. This is because they are lending less and raising more deposits (deposits are outpacing lending by 6% pa). The estimated funding requirement is noted below. If the banks were required to raise all of FY12 money at current elevated costs then it would have a small negative impact on margins of around 0.03-0.05%. If funding markets were to close entirely they could tap the RBA repo market.

3. Lending growth is likely to remain subdued in light of the negative sentiment.  Zero percent growth in business lending and only 4% growth to housing lending would lead to a small negative to profits of around 2%.

Balance sheets of corporates and consumers are in better shape than during the GFC.

Markets are anticipating a fall in interest rates which will further support repayments.

Banks balance sheets are much stronger.

Banks capital levels are higher than in 2007. The banks are required to hold Tier 1 capital to provide a buffer should economics deteriorate. In 2007 they held Tier 1 capital of 6.5%. Roughly this means that 6.5% of their loans were held as capital. They now hold more than 10% as Tier 1 capital (with a greater % ordinary equity).

Banks also hold provisions for future bad debts. In 2007 they roughly held 0.8% of loans as provisions whereas they now hold more than twice that amount.

Banks European sovereign exposure appears low

Conclusion: Market pricing seems to be anticipating a very negative hit to earnings which is difficult to justify and unlikely to occur. However sentiment is entrenched and needs a break from the negative newsflow.  In particular a recapitalisation of European banks would be useful.

 

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