Income Report / Income Report; Banks – is it all just too hard? (CBA, WBC, ANZ, NAB)

By Market Matters 17 October 18

Income Report; Banks – is it all just too hard? (CBA, WBC, ANZ, NAB)

Market Matters Income Report 17th October 2018

The ASX 200 has bounced well this morning, trading back up above the 5900 level at time of writing. Banks a large part of the move with ANZ +0.59%,  CBA +1.69%,  NAB +0.66% and WBC +1.62%. We’ll cover the banks in today’s report. Elsewhere, a slightly weaker than expected production report from BHP has that stock down around 1% while the big mover was The Reject Shop  (TRS), down ~40% after a profit downgrade. We discussed  TRS in the Income Report a few weeks ago (click here)

After re-jigging the portfolio last week, reducing exposure to hybrids and increasing equities exposure by 6%, the portfolio is now more heavily weighted towards more volatile equity returns. Currently we have  ~58% of the portfolio allocated to equities, ~37.5% in defensive income securities (hybrids / Bonds and the like), and 4.5% cash. That’s still a defensive stance but less so than before the market fell over last week.

For the week,  the portfolio dropped by -1.06% against the backdrop of the market that fell -2.83%. For the financial year to date, the portfolio is just in positive territory up +0.32% versus its benchmark of RBA cash rate +4% which sits at 1.61%. The ASX 200 is now down over 5%.  Since inception (5th July 2017) the portfolio has added 6.34% versus its benchmark of 7.05%, with this week being the first where the portfolio as ticked meaningfully below its benchmark since inception.    

Banks – is it all just too hard?

Banks are certainly on the nose and rightly so, some of the examples of poor behaviour coming from the Hayne Royal Commission were simply damming. When the Royal Commission was announced, a Senior Banking Analyst from the one of the well-known research houses suggested… "I don't consider the royal commission, or potential outcomes from the royal commission, will have any impact on the underlying fundamentals of the four major banks. And in particular, I don't see the wide economic moats being diminished in any shape or form. I see the banks' strong competitive advantages retained. I think it’s a good outcome for the major banks because most of the previous issues, allegations of misconduct have already been dealt with or are in the process of being dealt with. So, this announcement of royal commission is really more politics than good policy."

In  fairness, they were not alone with this assessment however 10 months on and the environment for banks has clearly changed. In the past week we saw the last of the big 4 put numbers around the cost of ‘making good’ their bad behaviour, both in terms of prior costs and the forecasts for future expenditure.  The below incorporates Bloomberg consensus data for earnings with the  announcements from the banks themselves & data from Shaw’s Banking Analyst, Brett Le Mesurier. 

 

These are projections for FY18 and FY19 for all bar CBA, which has already reported FY18 numbers (their FY18 number also includes AUSTRAC which was a CBA specific issue). The numbers above are now all known knowns, the market has digested them, and clearly they are bigger than anyone foreshadowed going into the Royal Commission. At a sector level its near on $5.2B over two years and if we throw in the amounts already spent to date + AMP, the number is around $7B, which is big.

The market will now price banks off FY19 earnings and we see an earnings hit of between 2.28% for CBA and 4.55% for ANZ – clearly from the above, CBA and WBC are positioned best moving forward.  While these are significant numbers, now they’re out in the market it’s one less piece of ‘uncertainty’ for the banks. Arguably, this should now become less of an issue.

Weakness in housing…

One interesting correlation is between bank share prices versus housing data, specifically auction clearance rates. National house prices have now fallen 2.7%  since peaking in September 2017,  with Sydney being the hardest hit down by 6.1% versus Hobart which was up +9.3%. To put these into context, over the past 10 years, national house prices have risen by 44% with Sydney up by more than 100% over that time. House prices are a national past time in Australia and right now the media are doing their bit to stoke concerns.

Over and above prices though, it seems to be the auction clearance rates that have the highest correlation to bank share prices. The chart below highlights this well over time. There is ‘noise’ in the data week to week however the trends tell a story. Auction clearance rates are now at their lowest levels since 2012, a time when ANZ, NAB  and  Westpac were all trading around ~$23 and CBA was around ~$55.

Financial Sector v Auction clearance rates

 

This all makes total sense. The availability of credit is a big driver of whether or not houses sell and it’s also a big driver of bank earnings. Tight credit = less borrowers = less sales.

The data below is fairly clear, insofar as banks have simply tightened credit, particularly towards investors. A loosening of credit and house prices bump up, volumes tick higher and bank share prices recover.

 

Bank valuations – all cheap but they need a catalyst

Banks are cheap, they pay a good yield and overall have been great investments over time, although less so recently. Within the MM Income Portfolio, we’ve bought banks too high however its hard the sell such ‘cheap stock’ that pay good income in an income portfolio. Looking at the banks amongst themselves, CBA’s usual PE premium versus the sector has now come back to just 5% while Westpac screens cheapest of the big 4 in terms of multiple and is close to CBA in terms of historical premium / discount to the sector.

Bank sector valuations

Drilling into Westpac (WBC) which is the bank we recently averaged into in the Platinum Portfolio, it’s the cheapest it has been in the last 5 years.

Westpac relative to history

 

That’s not to say banks can’t go lower, they have in the past and they will do at points in the future but it’s generally when they’re financially stressed – currently that’s not the case. The dynamics that are playing out in the property market in terms of auction clearance rates along with the volume of sales are not indicative of a housing market about to crash. They are indicative of banks making it harder for buyers to borrow money and ultimately reducing the number and capacity of buyers in the market, which puts pressure on housing, something the RBA was wanting to achieve in any case.

We remain keen on WBC around $26/$26.50 and sophisticated investors could look to sell call options above $28.00 . CBA needs to close above $70 and that would look bullish from a technical standpoint

Westpac (WBC) Chart

Commonwealth Bank (CBA) Chart

Summary

The Royal Commission has clearly been bigger than the market had factored in, however the cost is now known.

Housing and specifically Auction clearance rates are very important for banks share prices from here

Have a great day!

James, Harry & the Market Matters Team

Disclosure

Market Matters may hold stocks mentioned in this report. Subscribers can view a full list of holdings on the website by clicking here. Positions are updated each Friday, or after the session when positions are traded.

Disclaimer

All figures contained from sources believed to be accurate.  Market Matters does not make any representation of warranty as to the accuracy of the figures and disclaims any liability resulting from any inaccuracy.  Prices as at 17/10/2018

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