Investors usually have some exposure to Australia’s banks. They’re over-represented in our ASX at 35% of the ASX300 index, compared with about 25% of the US S&P500 Index. It’s because Australia’s industrial base has been hollowed out by the decline in manufacturing. So, if you just buy the overall market, you’ll be heavily exposed to banks. In the past this has been fine as they’ve had a dream run since the last recession in ‘89/90. But what’s the outlook for banks from here?
Regulatory Review/Royal Commission
The effect of the coming bank enquiry on shareholder returns is hard to guess. We can expect higher compliance costs, embarrassing media coverage and prosperous times for lawyers. Persistent political pressure is likely to make it hard for banks to deliver significant profit surprises in the short term. The market may initially react negatively to these inquiries, so it may be wise to keep some cash back for any buying opportunities that arise.
Otherwise, the current rather challenging environment is expected to persist. Bank earnings will be held back by low borrowing demand, technological disruption, higher capital requirements and regulatory impacts. Even so, current bank share prices seem fair and offer good dividend income that may increase over time – if not, their capital security should strengthen now that the regulator has established new rules.
Impact of rising interest rates
Higher bond yields are having a negative effect on share prices. The prospect of higher inflation could also reduce demand for defensive yield stocks in favour of cyclical growth stocks. So while interest rates are rising, it will be hard for banks to outperform. Higher interest rates directly affect bank share prices as their dividends are compared to a higher risk free rate (cash) – this increases the discount rates used in valuations.
Bank operating performance
Rising interest rates are normally in reaction to an improving economy. Some effects of higher interest rates on bank operations are as shown below:
Essentially banks sell debt – it’s their main product but in the short term it will be difficult for banks to expand their profits by charging more, due to:
- heightened political and regulatory pressures,
- high household debt
- possibly weaker house prices
- these may slow demand for debt and increase competition.
Trends in housing and credit
Mortgages are the main source of both quantity and quality returns for banks. So what are the trends that affect demand for home loans?
House price rises are moderating, which will reduce demand for mortgages. Household debt is still high and rising living costs (utility costs, etc) also constrain growth. APRA regulatory intervention recently created a trend away from ‘interest only’ loans. Intense first home buyer competition will also make it hard to grow profits.
Improving economic conditions should boost business lending but this is less profitable than mortgages, as it needs more capital and creates higher bad debts. Personal loans are not in demand as consumers prefer using their lower cost mortgages, which are more profitable for banks anyway.
We expect slower growth from bank stocks than the past 25 years. An ‘underweight’ position in financials may be wise, perhaps to about 20% of the Australian Equities portfolio (they’re 35% of the ASX 300). However, a meaningful exposure to the banks still seems worthwhile for their attractive fully franked dividends – particularly useful for super and pension accounts. Our current 10-year return forecast from December 2017 for Australian Equities was almost 8% p.a. Since banks now offer a grossed-up dividend yield of 8%-10% p.a., negligible growth is required for these stocks to warrant a portfolio spot.
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Disclaimer: All information in this article is intended to be general in nature for discussion purposes only. So you should not rely on it and seek personalised professional advice before making any decision.