What is the market banking on?
With much of the financial media focused on the announcement of an ACCC probe into the residential mortgage sector this week, we cast our gaze on the banks, their recent contribution to the market’s performance and their future prospects.
The top 300 companies by market cap (ASX300) rose 2.55% in the September quarter. Banks and financials outperformed the broader index (+3.12%), assisted by a small spike in bond yields early in September, along an ongoing unwind in concerns related to the Royal Commission.
A decision in the ASIC responsible lending case, which was seen as supporting ongoing loan growth, also assisted. The topic of responsible lending is critical to the outlook for the banks, as their profitability will be determined by how “responsible lending” is defined and how “responsible” they have been when lending in the past.
Just what is “responsible” lending?
An important court case launched by ASIC against Westpac has sought to clarify the responsibilities of lending institutions to understand and consider information provided by a client when seeking to obtain a loan. Questions included the degree to which a bank (in this case) should assume that expenses declared by an individual would represent an impediment to paying a loan off: whether the loan was reasonable, so to speak. You might think a bank would be conservative in such a circumstance and not simply take the applicant at their word that such expenses as declared would be likely to continue. Better safe than sorry!
But with weak wages growth, and expensive housing, procedures which looked at actual expenses as the principal driver of affordability could limit the amount of borrowing the bank could undertake. As such, banks often assume that people will respond to having a large loan by cutting expenses down towards the so-called HEM measure, similar to a poverty line for mortgage holders. Justice Perram agreed with Westpac and the implications of using a HEM instead of historical expenses when he noted:
"Knowing the amount I actually expend on food tells one nothing about what that conceptual minimum [of how much one can spend without going into "substantial hardship"] is. But it is that conceptual minimum which drives the question of whether I can afford to make the repayments on the loan." (Source: ABC News).
Perhaps more colourfully, Justice Perram also elaborated:
"I may eat Wagyu beef everyday washed down with the finest shiraz but, if I really want my new home, I can make do on much more modest fare.”
ASIC disagrees with Justice Perram and will appeal to the full bench of the Federal Court.
Regardless of the outcome, we would prefer to invest in banks that were writing the highest-quality loans, not just the most loans. The market disagreed this quarter, at least in the short term, as maintaining the flow of home loans at current levels is seen by many as a minimum requirement for the health of the economy, regardless of the impact on the long-term value of the banks. We are sticking to the long-term implications, in which such loans will ultimately increase the risks to the earnings quality and capital adequacy of the banking sector.
As a tail risk, the type of systematic risks that poor loan quality can encourage tends to produce outsized impacts, much more problematic than a foregone shiraz could imply.
Banks and your portfolio
Your portfolios have no exposure to bank shares. The thesis for this position is clear:
1. Price-earnings ratios remain elevated (see chart below)
Source: FactSet, Macquarie Research, Oct 2019
2. Earnings momentum is in reverse, and has not been assisted by declining interest rates. Sustained very low-interest rates weigh on net interest margins and hence bank earnings power
Source: FactSet, Macquarie Research, Oct 2019
3. Mortgage growth is weak, and loan quality uncertain
4. International evidence (especially from the UK) suggests the costs of culture and compliance programs remain elevated for extended periods.
5. Risks are emerging from fin-tech firms in areas of growth and high profits (such as foreign exchange), and competition is increasing in the niche crevices of finance that large banks operate in.
Avoiding the banks for the past 5 financial years has proven beneficial in relative terms. The following chart shows the relative performance of the 4 major banks (simple average including dividends) versus the ASX300 Accumulation Index.
Source: IRESS, First Samuel
The nominal appeal of a large full-franked dividend always plays large in the psyche of bank investing in Australia, as does the tremendous performance of listed equities in the banking sector since deregulation.
For the decade to 2014 Australian banks outperformed the index (which includes banks) by more than 3.1 per cent per annum. Including franking credits, and depending on circumstances, this may have added 1.5 per cent more outperformance. But this was also a period in which interest rates fell considerably, there were few bad debts, the banks survived a GFC largely unscathed and few questioned the behaviours encouraged with the banking sector.
When will we buy banks?
This is the most important question. There are two answers. The first is: banks don’t all trade at the same prices. When an individual bank's share price provides an opportunity, we will buy such a bank. Such a purchase is likely to make a better, more diversified portfolio. The second is: we will buy banks in general when their earnings quality is better (sustainable interest margins, clarification of remediation and technology costs) and when the price to earnings ratio reflects the risks inherent in the banking sector.