For the best part of two decades, Australian banks enjoyed a golden period of share market outperformance. The banking sector was able to deploy significant capital at very attractive rates of return. It has only been since 2015 that the banks have underperformed the ASX 200 on a consistent basis.
The recent underperformance of banks has been driven by a combination of tightening global capital requirements, tightening credit standards, rising compliance costs (Banking Royal Commission) and a derating of valuation metrics. Undoubtedly, significant headwinds remain for the banking industry. Indeed, earnings per share growth is expected to remain muted for the banking sector over the forecast period.
The state of the housing market remains fundamentally important for the outlook for retail banks. Economic conditions for the housing market remain challenging, with the expectation of further declines in property prices coupled with moderating credit growth. Nevertheless, mortgage delinquency rates should remain at manageable levels supported by interest rates remaining at historically low levels and employment levels remaining stable. It is noteworthy that over the previous two decades mortgage losses have remained benign despite periods when house prices have declined. However, vigilance on monitoring the current credit cycle and the potential rise in non-performing loans (NPL’s) remains of paramount importance.
But... bad news all priced in?
We would contend that there is now a great deal of negative information already reflected in the retail bank share prices.
Valuations for the banks are now looking interesting, most notably with Return on Equity metrics decreasing to more sustainable levels.
Commonwealth Bank is appealing to us, as earnings and valuation metrics have suitably moderated to more viable levels. While we expect Commonwealth's earnings profile to show only low single-digit growth over the forecast period, its capital position and ability to continue to pay high dividends offers support.
In general, with the trajectory of earnings growth moderating for ASX companies, Commonwealth’s low growth and maintainable high dividend yield provides appeal.
Importantly, CBA is well placed to exceed APRA’s mandated 10.5% “unquestionably strong” CET1 by January 2020.
CBA’s dividend should be underpinned by its strong capital position, providing investors with an attractive c. 6% fully franked dividend yield. With interest rates expected to stay at/or near record lows, dividend income remains a compelling source of income.
No mention of Shorten and Labor possibly damaging the banks with their policies on franking credits and negative gearing. This is a huge issue which must be factored into the share price of banks.
Undoubtedly, there are a number significant headwinds which the banks need to navigate through, including recommendations that will emanate from the Financial Services Royal Commission coupled with the prospect of greater government intervention (if the ALP is elected in the Federal election). How much of this is factored already into banks share prices is difficult to determine. A further consideration is the the potential change in the composition of bank share ownership (which is dominated by retail investors) who have been beneficiaries of fully franked dividends. If franking changes are implemented by a new ALP government the mix of share ownership may shift toward greater ownership by local and foreign institutions.