With many retail investors and SMSFs already fairly heavily weighted to bank shares, suggesting that this might be the time to increase exposure to banks might sound somewhat imprudent. More so given the tough start to the year for the shares of the major banks.
Since the start of the year, Commonwealth Bank (CBA) has lost 17.3% (15.0% adjusted for the $1.98 dividend), Westpac 14.9%, NAB 19.2% (16.2% adjusted for the CYBG demerger) and ANZ, the laggard, 19.2%.
Compared to Europe, these don’t look too bad, where the STOXX European 600 Banks Index is down 19.5%. Over in the US, the S&P 500 Financials index is only down 10.9%.
Why are banks on the nose?
Banks are on the nose globally for a number of reasons. Firstly, there is the widespread concern about slowing economic growth. The IMF, for example, recently downgraded its 2016 forecast for world economic growth to 3.4%, and for 2017 to 3.6%. Slower economic growth means reduced opportunities for banks to lend money and grow income.
Couple this with the spectra of negative interest rates, which could really put the squeeze on bank margins.
And then there is the impact of falling oil and metal prices. Banks will have lent money and provided accommodation to companies involved in the production, distribution and servicing of these industries. The market fears that there may be some horrible exposures, leading to large write-offs.
In Europe, you can throw in a couple of other factors. The ongoing problems in Greece and potentially Italy, and challenges with the union, as Brexit becomes a possibility.
The Australian market is also suffering from the usual fears about the property market (and banks’ exposure to housing). Last week, a Dr Jonathan Tepper got massive coverage when he prophesized that the Australian housing market is going to implode, bringing housing prices down 50%. He joins such luminaries as Professor Steve Keen and Jeremy Grantham, who have been tipping this for years!
Add in another consideration that Australian banks are overvalued compared to their international counterparts using ratios like price/book, which has fueled rumours that offshore hedge funds are selling short Australian banks.
Are the short sellers active?
The latest ASIC data suggests that there has been an increase in the short selling of bank shares. For example, 2.60% of Commonwealth Bank’s ordinary shares, or 44.3m shares worth about $3.2bn, are currently short sold.
As the following table shows, 207.5m shares of the major banks are short sold. While this number is on paper rather alarming, it is only roughly double the number of shares that were short sold 6 months ago, or roughly three times the number12 months ago. Short positions always increase when the market is under pressure (due to institutions and others hedging), and in comparative terms, the major bank average of 2.01% of ordinary shares sold short wouldn’t even make the list of the top 50 companies most shorted. Woolworths, for example, is ranked 16th on the list, with 9.73% of its shares sold short.
Short Positions in Major Banks – % of ordinary shares and number
* ASIC reports short trades after they are settled
What could go wrong?
One question is what do the short sellers know that we don’t know? In the days of continuous disclosure, my guess is not a lot more. Another more interesting question is what could go wrong to make them right?
I suggest there are four things. Firstly, if bank and financial stocks continue to weaken in Europe and the US, it will be hard for our market to stay immune from this pressure. Whatever metric is used to compare bank valuations on a global basis (and I argue that book value isn’t the most useful measure), if bank stocks are cheaper in other markets, then our bank shares will look comparatively more expensive, which will put pressure on their prices. You can’t stand in the way of the train.
The next two relate to the housing market, and the importance (some argue dependence) our banks have on a stable housing market. What could cause a housing crash? Interest rates rising rapidly? Much higher unemployment?
No chance of interest rates rising rapidly. Higher unemployment, which could push borrowers into a default situation as they struggle to repay their loans, is a possibility, but is still pretty unlikely. And we are not talking about unemployment increasing from 6% to 7% – it would probably need to go as high as 10%.
And as the following chart of home loan arrears for the Commonwealth Bank group shows (Bankwest in grey, Commonwealth Bank in yellow and Auckland Savings Bank in blue), there are no signs yet of any deterioration in the credit quality of the banks’ housing portfolios.
Finally, the banks will need to continue to boost their capital levels. If the timing of this is brought forward, or the regulator (APRA) takes a more aggressive stance than is currently anticipated by the banks, then we could see heavily discounted rights issues. However, I rate this as unlikely, as the timing of the Basel IV reforms is being pushed out and the Banks have already taken action in advance of the change to mortgage risk weights on July 1.
For sure, the return-on-equity for bank shareholders will fall as banks issue more shares through non-underwritten dividend re-investment plans and/or sell non-core assets. Shareholders may also see lower dividends.
Which bank?
Let’s start with what the brokers think. According to FN Arena, they are reasonably positive on the sector and in a valuation sense, see upside of between 10.6% and 18% for the major banks.
There is a big difference in earnings multiples. Commonwealth Bank is trading at a multiple of 12.7 times FY 16 earnings, while ANZ is trading at a multiple of 9.2 times and NAB at 9.7 times. This means that Commonwealth Bank is trading at an effective premium of 38% to the ANZ and 31% to the NAB.
Notwithstanding the pricing premium, my preference is to stick with the Sydney HO based banks over the Melbourne banks. I think NAB has potential, but as new CEO Andrew Thorburn is learning all about, it takes some time to turn these institutions around. Over at the ANZ, Shane Elliot has just started in the job and there are concerns about their Asian exposures.
Without a lot of conviction, my ranking is
- Commonwealth
- Westpac
- NAB
- ANZ
Banks are in the buy zone, however in the short term, offshore leads are likely to drive our market, so patience will be required. In the long term, investors should be rewarded.
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