Australian investors love Australian banks as they are known to be some of the most consistent dividend income and relative level of income protection it provides. The fall in the big 4 share price recently is an ominous sign for the market and the Australian economy in the future.
The big four major banks historically made up one of the largest sectors in the major market indices like the ASX 100 or ASX 200. The weak performance of the banks’ share price will have implications on the market index. We see the following risks currently overhanging the bank share prices.
- The Australian banking sector will face blowback from increasing unemployment and weaker property prices in the short and medium-term. The increase in the bank’s non-performing loan book (i.e., loan losses) will reduce earnings directly.
- In addition to this, the consistent border closures and snap lockdowns create a high level of uncertainty and hit business confidence.
- The weaker macro context will weigh on sentiment to the sector for the foreseeable future.
We consider these to be major factors that are playing in the banks’ boards’ minds and the key reason that the dividends could be held the same or cut. We don’t see any immediate resumption of dividends until the economic effects of the Coronavirus have felt through the economy.
Big 4 Bank Share Returns
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Australia Bank Share Prices
The performance of the cohort Australian bank shares is relatively consistent. CBA can be an outlier, which we attribute to its stronger capital position compared to the other major banks in the same big 4 cohorts.
Banks are not growth shares. Investors have always been attracted to the passive income stream of bank dividends. The recent patchy share price performance shows the importance of dividend income as a share of the total return makeup.
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Why is Macquarie’s different from the other Australian banks?
We included Macquarie bank to show a slight variation as a result of exposure to capital markets and funds management. The big 4 banks are known as commercial banks instead of Macquarie, an investment bank. Commercial banks focus on lending to consumers and corporate using their balance sheets. In contrast, investment banks are active in mergers advisory, sales trading and other capital market facing activities.
Macquarie is Australia’s largest investment bank. Coming out of the financial crises, it is also the only survivor out of all the listed financial engineering banks (Allco, Babcock and Brown).
Post crises, Macquarie shifted its business to be less reliant on volatile parts of the market, such as corporate finance and sold its listed infrastructure vehicles’ management rights.
Now the business focuses on asset management, where it is one of the world’s largest infrastructure asset managers.
Macquarie’s earnings, while less dependent than previous incarnations of the business, are still reliant on the global capital markets’ health and confidence. It taps into London, Hong Kong and New York markets sourcing deals, advising clients and raising capital.
It is still Australia’s largest investment bank with blue chip corporate finance contacts and cash equities business. However, the MQG tracks the performance of the broader banking sector. The company has a completely different risk profile versus the likes of the big 4.
Why did the banks cut the dividend and raising capital now?
Banks are a leveraged play on the economy as they borrow short and lend long with enormous leverage. If you know, earnings are going to be weak or expecting losses. The most conservative action is to preserve capital and raise money when you can rather than when you need to like during the GFC.
An optimist can see this as a more precautionary move than expecting actual losses like the last crisis. The short term loss in income can be seen in the context of preserving the long term value.
Banks at their peak traded on two times their book value with a mid-teen ROE. The return on equity will decline following the capital raise and lower earnings, but it increases the business’s resilience to handle the shocks that will undoubtedly come.
Don’t expect a repeat of pre covid earnings.
Previous strong earnings are what you would expect from a booming residential real estate market and will not be repeated for several years and will not be a guide for earnings in the future. Cyclical stocks are cheapest at the peak of the cycle as investor discounts future decline in earnings. The most recent earning report shows evidence of increased provisioning in bad debts in Australia and offshore.
Previous regulatory pressure on loan book growth helped.
The housing market already cooled off in 2018 and 2019, so it didn’t overshoot in the last boom. The banks previously raised capital in 2015 and 2016 to shore up their position in response to APRA increasing capital requirements which was a great move and prepared the big 4 banks for this crisis.
The banks already responded by cutting lending to commercial real estate, which can be considered one of the riskiest forms of lending. This led the rise of non-bank lenders debt funds, which filled the gap and reduced some exposure off the books.
The lending market’s overall condition is good as it could be given the Australian regulators already pressured banks to slow investor mortgage lending during the book to remove the risk of a housing bubble in the Australian residential market.
The downside of this is that the higher capital drag on earnings will continue for the foreseeable future.
Unemployment and Property Prices
We always considered unemployment and house prices go hand in hand. The Australian economy’s resilient performance during the financial crisis and the fast bounce back as a result of the mining boom followed was the key reasons the property prices stayed relatively stable and took shortly after.
Unfortunately, the 30 years of uninterrupted run of economic growth is over. This recession will be a domestic led recession where the cut back in spending resulting from the lockdown is already impacting the job market. The weakness in the job market will continue with a delayed but pro-longed impact on property prices.
The big four banks have a huge residential mortgage lending book and is one of the largest components of the loan book and contributor to bank earnings. Any housing weakness will hit earnings materially from now on. To this end, it is not something that can be resolved in one or two reporting periods, but we think over several years.
What hasn’t yet been factored in is the expected increase in business loan losses due to closures and upcoming bankruptcies. The residential loan book is an obvious segment, given its size and visibility. The business losses resulting from the prolonged economic weakness will be just as severe but will take time to play out.
The market has turned for bank shares. Investors will always be tempted for bottom fishing; however, weak job growth and consumer sentiment will not turn anytime soon.