Key points
- The correction in the domestic banks has occurred due to a spike in bond yields and the imminence of new global and local regulations requiring banks to hold more capital, theoretically implying lower earnings and dividends.
- However, the search for yield theme hasn’t been undermined by these recent events.
- Investors in banks are receiving a 600 basis point risk premium against a further rise in global yields.
The sharp correction in the domestic bank sector has seen -15%+ falls for the major Australian banks (-20% plus in US dollars). With the big four banks alone representing 30% of the benchmark S&P/ASX 200 Index, this has driven an associated 370 point pullback in the S&P/ASX 200, reminding you how concentrated the Australian market is. Banks are most likely closer to 50% weightings in the average SMSF in pension mode, therefore it is understandable that my inbox gets inundated whenever there is a bank sector pullback.
In recent email responses, and in discussions at presentations, banks have now become the main topic dominating domestic investor interest. There are three questions regularly asked. Why have banks fallen so far? Is the search for yield over? If so, do I sell banks now?
Why have banks fallen so far?
The Australian banks have been harshly treated for two reasons. Firstly, government bonds had become mispriced due to QE policy and the subsequent search for yield. This mispricing finally led to a violent unwinding of a very crowded long trade in government bonds, particularly the German bund, which in turn has led to a profit taking rally and a spike in global long bond yields. That now seems to have settled down a notch, with Australian 10yr bonds back down to 2.89% from a recent high yield of 3.05%.
In Australia, the search for yield has manifested itself in the demand for fully franked bank dividends. This demand has distorted traditional valuation criteria with banks being priced on yield rather than earnings multiples. Naturally, any rise in bond yields (the expectation of future interest rate levels) will have a detrimental effect on interest rate sensitive stocks (banks). As a result, the spike in global bond yields has sparked a savage correction in yield-based asset prices, particularly Australian banks, which have the highest dividend yields in the developed world.
Secondly, the rise in bond yields has occurred against a backdrop of new global and domestic regulations requiring banks to hold higher capital ratios. The global regulations require all banks to hold higher overall Tier 1 capital under the Basel rules. To date, Australian banks have made reasonable progress in attaining the new global regulations.
The new Australian regulations proposed under the Murray Financial Services Inquiry, require banks to hold more risk-weighted capital against residential mortgages. The consensus is that between $15-$20 billion in new capital will need to be raised by the major four banks. In the recent $5.5 billion NAB rights issue, $2.2 billion was allocated to meet the new domestic regulations, while Westpac has raised $2 billion from its dividend reinvestment program. Meanwhile, both capital raisings, particularly the NAB rights issue, have only served to exacerbate the share price weakness.
The conventional wisdom dictates that less capital to lend equals a lower rate of return on equity, which ultimately leads to lower profitability and slower dividend growth. The new capital regulations set against rising bond yields has created a perfect storm for the domestic banks sector. In the ensuing hysteria, some are viewing the correction as proof that the recent era of bank outperformance is over, while many brokers have adopted underweight positions on the sector.
In summary, the answer to the first question is: the savage correction in the domestic banks has occurred due to a spike in bond yields and the imminence of new global and local regulations requiring banks to hold more capital, theoretically implying lower earnings and dividends.
Is the search for yield over?
Now let’s look at the second question. Is the search for yield over? As I have mentioned many times previously, the search for yield is a global theme driven by financial repression. In simple terms, central bank policy has artificially compressed both short and long-term interest rates, which has lowered the returns for cash and cash equivalents, such as bonds and term deposits. As a result, investors are forced into more risky asset classes such as equities and property in search of higher yield.
So, does the recent spike in bond yields invalidate the search for yield? No, is the short answer. Here’s why. Bond yields are a future reflection of the expectation of short-term interest rates, which in turn are driven by economic growth and inflation expectations. Currently, with the exception of the US, global growth is anaemic and inflation remains at historic lows. Even the US economy is sending mixed growth signals. More importantly, the Fed has categorically stated that any rate rises will be slow and measured.
Investors appear more concerned with the timing of the first move in US interest rates, rather than the magnitude of the subsequent rate rises. Let’s look at the facts. The official forecast for the Fed Funds Rate (cash rate) at the end of next year is still just 1.75%. Rather than ultra-low, US cash rates will still remain extremely low, relative to history. The search for yield is far from finished.
Although the Fed has finished its QE policy, the other major central banks have the monetary taps turned fully ON. Incredibly, the size of the current QE programs operating by the ECB and BOJ have the capacity to buy 100% of the planned sovereign debt issuance of both regions for the next 12 months. Meanwhile, the Bank of England is still operating its own QE program. Clearly, long government bonds remain badly mispriced, but in the medium term, central bank policy is committed to ultra-low bond yields and even lower cash rates.
There’s no doubt that central bank policy has created another asset class bubble. Like all the others, it too will end badly. The recent spike in bond yields is a warning. At the same time however, history shows that the catalyst for all bond bear markets and crashes (there haven’t been many) all began with an aggressive tightening of US monetary policy. At the moment, the Fed remains dovish. History also dictates, ” Don’t fight the Fed.” In short, my view is that the rise in bond yields is a correction, rather than a warning that global cash rates will rise dramatically. As such, the search for yield theme hasn’t been undermined by recent events.
Do I sell banks?
That brings us to the third question. If the search for yield is over, do I sell the banks? Given my benign view on bond yields, the obvious answer is no. Here’s why. As I have mentioned, the Fed expects the US cash rate to be just 1.75% by December next year. In Australia, the RBA basically admitted a policy error recently (as I predicted [1]) by reiterating that any further rate cuts will remain policy dependent. At the same time, the RBA downgraded its forecast for 2015/16 domestic GDP growth by a 0.5 percentage point. By implication, a further rate cut is likely with any additional economic weakness and any further strength in the Australian dollar. My view is both outcomes remain highly likely to occur.
After the recent correction, the big four banks are yielding over 5% fully franked once again. This implies a tax effective yield of nearly 8% grossed up for franking credits. This compares to a NON tax-effective cash rate of 2% with a good chance of a further rate cut to 1.75%. At current levels, bank investors are receiving a 600 basis point premium for investing in bank dividends rather than cash. Put another way, investors are receiving a 600 basis point risk premium against a further rise in global yields. I’m a simple man but the risk/ reward appears very skewed in favour of fully franked bank yield.
Add on any weakness
The recent hysteria over an expected decline in bank earnings and dividends due to higher capital requirements also appears misplaced. On consensus expectations of $15-$20 billion in additional funding required to meet the new regulations, both NAB and Westpac are nearly 50% complete. In particular, Westpac has raised $2 billion by merely underwriting its dividend reinvestment plan. In addition, the expected fall in bank profitability appears dependent on static earnings from the bank’s other divisions. Just recently, net interest margins were supported by banks not passing on the full rate cut. The banks have many growth levers to offset changing industry conditions. I don’t see the new capital requirements as draconian.
The residential housing bubble is another perceived risk for bank earnings. With the exception of Sydney, national house prices are growing at just 4-5%. Even more importantly, the loan to value ratio across the major banks indicate that the average mortgagee has nearly 50% equity. Bank bears have been calling an end to bank profitability for years but to date it has failed to materialise.
In Australia, dividends have contributed roughly 60% of total equity market returns. In the last decade, bank dividends have been cut just once, which occurred in the GFC. In a low-growth, low-return environment, with a cash rate of just 2% (and risks it goes lower), it makes no sense to sell bank shares. Particularly within the tax effective superannuation umbrella, where a superannuant receives an ATO refund for the franking credits. My advice is don’t sell banks but add to existing holdings on any weakness.
The final chart confirms that Australian Government (AGB) 10yr bond yields (blue) and the ASX200 Financials Index (XFJ) (green) are extremely inversely correlated. With AGB 10yr yields reverting to yield downtrend as Australian economic data remains sloppy it is fair to expect a bounce in the financials index from these oversold levels, led by the beaten up major Australian banks.
Shut your eyes and buy one of them today is my advice to Australian investors who can value franking credits.
[2]Australia for income, rest of world (ROW) for growth.
Go Australia, Charlie
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.