(Ed’s Note: We asked two of our contributors who have strong views on banks to produce a bear versus bull case on this critical sector for income investors and SMSFs. Below, Damien Klassen provides the bear thesis. Follow Romano Sala Tenna, who has countered Damien's views with by publishing his bull case for the banks.)
What's our medium to long-term outlook on Australian banks?
We are not positive on Australian banks in the medium term.
Australian banks will have a time to shine again. That time is not while staring down the barrel of the highest unemployment rate seen since the Great Depression and an extended period of close to zero interest rates.
These are not company-specific issues, rather the banks are facing incredibly challenging macro-economic conditions on two fronts.
The first front is the risk of a debt crisis coming either through business lending or a housing market crash.
Even if banks somehow manage to avoid the effects of a debt crisis, they are facing a second front of an extended period of low interest rates.
Neither are attractive for banks: The acute crash of a debt crisis, or the chronic grind lower of low interest rates.
The damage is already done from the shutdowns. Even if there was a coronavirus cure tomorrow, we are facing:
- Mass unemployment. Unemployment tends to take years to recover.
- Depressed wage growth, held down by high unemployment.
- A demand shock from consumers looking to increase savings.
- Our economy has been driven for a decade on the willingness of consumers to increase debt at growth rates far higher than income growth. We are expecting low debt growth at best, more likely to be negative.
- Companies that are looking to deleverage. Meaning lower profits.
- Companies that are looking to increase the slack in their supply chains. Meaning lower profits.
- Companies and governments looking to repatriate supply chains to reduce reliance on imports of critical medicines, food or equipment. Meaning lower profits.
- Small and medium businesses going broke.
- Falling rents, dramatically reduced immigration, reduced student numbers, increased vacancy rates all weighing on property prices. Property prices are likely to drop significantly.
- Banks increasing credit checks and decreasing credit availability.
There will be offsets. There will be government stimulus. But these will reduce the depth of the downturn, not prevent a downturn.
- Australia (through commodities) has leverage to world growth. When world growth is good, Australian growth is very good. But when world growth is bad, Australian growth is very bad. World growth is not good.
- Australia started with the 2nd highest consumer debt loads in the world. This makes Australia, and Australian banks, more susceptible to a debt crisis.
- China is still operating 10-20% below pre-crisis levels. i.e. Australia's largest trading partner, after months of being open, still has 10-20% less demand for goods and services than a year ago.
So, Australia has all of the ingredients for a debt crisis. Will we manage to avoid one? It seems unlikely.
Extended low interest rates
The Reserve Bank of Australia has explicitly guided to keeping interest rates low for a long period of time. The general theory is the RBA wants to get more economic activity to decrease unemployment and lift inflation. By lowering the interest rate:
- Consumers with home loans save money. For a small proportion, this means that they can afford higher house prices and so bid up the value of existing houses. For other consumers with home loans, the cost savings and the confidence from higher house prices translate into greater consumption spending.
- It becomes cheaper for businesses to borrow to invest. The mix of more consumer spending and less expensive loans means that more firms invest.
The combination of the two is a virtuous circle that then employs more people, which creates more consumption and more business investment and so on.
However, these are reliant on three expectations:
- Banks will lend more money as interest rates fall.
- Consumers will be confident enough to take out the loans
- Businesses will be confident enough to take out loans and expand
The problem is banks have different incentives in their business model: low-interest rates are not necessarily better. If interest rates are too low, it can be a disincentive for banks to lend. As we have seen in both Europe and Japan.
At the simplest level, banks are an asset/liability mismatch. In essence, banks borrow from depositors (and others) on a short term basis and lend it out for long periods.
So, banks make the most money when short term rates are low (borrowing is cheap) and long term rates are high (lending is expensive). This is called a steep yield curve. The actual level of interest rates is far less important than the difference between the two interest rates. But, as many depositors know, banks stopped paying interest on most transaction accounts a few years ago. So banks can't lower interest rates on those accounts any further to reduce costs. This means lower rates don't decrease bank costs for at least part of a bank's liabilities.
The other part of a bank's liabilities is more complicated. The short version of the story is yield curves are very "flat" (rather than the profitable steep curves), and so there isn't much relief on that front either.
The net effect: rates cuts for banks are going to eat into profitability. Europe has been facing this conundrum for years. How do central banks keep rates low enough to stimulate the economy but not send the banks bankrupt? And that is where Australia now finds itself.
How do you we explain significantly underweight bank exposure to income investors chasing dividends and franking?
I wrote a few months ago on Livewire that Australian Bank dividend yields are unbelievable. And not in a good way. Since then we have already seen the first round of dividend cuts from the banks. I don't think that round will be the last.
So, the dividends aren't secure and you run the risk of losing all your yield in capital losses.
I can understand (but not agree with) investors buying banks because they have a rosy view of economic outcomes and expect capital growth.
I can't understand investors who are looking for safe, steady income choosing Australian banks.
Are there any trigger events that would make us change our mind and buy banks?
Lower share prices.
Where do we think investors can find better income opportunities and why?
I'll answer this question practically first and then philosophically second.
Practically, we are looking for a mix of income, income growth and portfolio stability for our income investors. I wish we could get all three through a single stock or sector, but the reality is we can't:
- For income and portfolio stability we buy a range of steadier industrial stocks like consumer staples where we see demand for their products relatively unaffected by the coronavirus.
- To this list, we add stocks where we are expecting dividends to grow over the next few years. The current yield may be average or even a little below average, but we believe growth will make the yield more palatable in future years.
Individually, these stocks are often more volatile than the income stocks of yesteryear, and so we tend to buy smaller amounts of a greater number stocks to provide more stability through diversification.
Philosophically, we live now in a low interest rate world. You can treat this one of two ways:
- Refuse to accept low dividend/interest rates of return. Chase the yields you used to get by investing in high risk stocks or bonds. Run the real risk of losing some or all of your capital.
- Accept that the world has changed. Invest in stocks that pay higher-than-average dividends that aren't higher risk. Drawdown on capital if you need to.
I see investors all the time opting for the first option. After being stung, they eventually migrate to the second.
What are our top 2 stocks for income?
After the above explanation of how we are approaching income, I'll highlight that we include these two stocks in with a range of other companies.
One area we have been looking for safety in income is the electricity generation sector. In our international portfolio, we hold Endesa, which is a Spanish company that generates, transmits, distributes, and supplies electricity in Spain and Portugal. The yield is over 6%, and we expect profits to be resilient to coronavirus inspired downturns. There is unlikely to be much growth in profits, but we do expect stability.
The other stock is more controversial. We allow investors in superannuation or personal accounts to ethically screen out particular sectors from their own portfolios, and many of them choose to screen out tobacco stocks.
For those that don't, tobacco stocks offer recession resilient income and 10%+ dividend yields. UK-listed Imperial Brands is one stock we own in that space. Once again, the capital outlook is constrained, we expect the dividend to be sustainable over the next few years but not in the longer term. So, it is not a "set and forget" stock. Contrary to many other stocks with high yields at the moment, the high yield in Imperial Brands is reflective of weak long-term growth, not short-term recessionary risk. Which provides an opportunity over the next year or two.
Like the analysis not the recommended stocks...
Great analysis Damien. Those who have benefited most from banks are massively overpaid bank executives, not shareholders (unfortunately). Need lower prices to be attractive to those who consider risk and return, such as yourself.
In terms of reducing interest rates, no one ever seems to do the full analysis. By reducing rates, yes you give mortgage holders and those with business loans a leg up, but you destroy even further the ability for those that live from investments in cash, to spend. I think interest rate reduction is a blunt tool that to a fair degree re-distributes income from retired folk to borrowers. And the borrowers are too scared to spend it. It seems to be the only economic tool used, and it is brutal to retirees, and pointless for the economy. On another note, I think any article that speaks to the banks as being either a good prospect or a poor one, surely must consider their current share pricing and say whether they have value at that price, and if not at what price they would have. Can't see that in this article and seems to me to be a major omission.
Thanks Martin, I wish I could give you sexier names! It is tough for income investors. As I said, we are blending names like these with higher growth stocks so that the portfolio effect is a reasonable dividend yield.
Banks will have their time in the sun again. But trouble is, the sun ain't gonna shine any more (or at least not for some time).
Thanks Damien, great analysis. The willingness to lend money is the key as you say. This is reflected globally too.
Thanks Robin for your comment. We did make a comment on share prices: Are there any trigger events that would make us change our mind and buy banks? Lower share prices. I agree that every asset has a price
Thanks Damien - thoughtful article. Couple of points that I would add that differ to your views though. First that while banks borrow short and lend long, this is the duration that mostly affects liquidity. The interest rate risk that the banks hold is much less as much of the interest rate on both side of the balance sheet head towards the 90 day rate (swaps as well as actual rates). You didn't mention the widening credit spreads which is actually a negative for banks, especially those that don't source as much from depositers. The post COVID world won't be as attractive for banks (but I don't subscribe to all the negatives) as the pre, but has this already been factored into the price? The bull case didn't centre on banks actually being a long term play (and in some ways could throw up some similar arguments to those you raise), but on the valuation discount. If nothing else changed, and assuming that you didn't think banks were going broke, when would you buy something like NAB? $10? $5?
Hi Brett, thanks for your comments. Romano and I wrote these in parallel - my article wasn't designed as a critique of his arguments which is why I haven't addressed your questions. I believe Romano's assumption on the valuation discount is based on avoiding a debt crisis (from small businesses or housing) and a return to "normal" conditions where Australian (private) debt growth is far in excess of income growth. Under that scenario, current prices look attractive. Rather than a single valuation, we look at different scenarios. One scenario has house prices fall 25% but there are only limited business losses and the commercial property sector is OK. Another scenario with the same outcome but losses in the commercial property sector and so on. Our models for what the banks are worth are based on a wide range of these possible outcomes and our view on the probability. At present, there are enough likely outcomes with valuations below the current prices that we are limiting bank exposure.
Thanks, Damien. If someone did not sell banks in February there is certainly no point in buying them now. However, if someone did maybe it is not so unwise to buy them now. Factors like: Mass unemployment, a demand shock from consumers looking to increase savings, and others you mentioned would affect all sectors and companies and maybe major banks with their AA ratings would be in a better position to survive the crisis than others. Lower RBA interest rates would be more helpful than detrimental for banks because their markup would not really change much. They will still have their 1.5-2% on top of RBA rate, however, for their clients, it would be much easier to pay mortgages. Also, we need to consider that by now banks are still at the bottom while many sectors had grown since 23 March. This is probably another reason to consider buying banks now. I certainly agree that the electricity generation sector should do well in the crisis. However, due to all factors, you mentioned energy demand should drop hence profits.
Excellent article. I intend sharing this with a very conservative investor I know in the hope they will make wiser choices for the dark and dismal economic road ahead. Thanks++