Perhaps the most important theme to emerge from recent bank reporting was that capital generation was stronger than anticipated as indicated by the CET1 ratios at, or around the ~10% level. This was predominantly due to a reduction in risk weighted assets. Why is this significant? Well in effect it strengthens the likelihood that the major banks will be able to maintain their respective dividends at the current levels into the second half of the financial year, subject of course to regulatory changes.
The biggest risk to banks in the next 12 months
The banking sector is facing a range of well-documented risks, including the uncertainty surrounding the cost of financing. Given the limited depositor base, the cost of off-shore financing and the ability of the major banks to pass on out of cycle rate rises is crucial to maintaining and/or expanding their interest margin.
Regulatory risk is also ever-present. In the coming 12 months we are likely to see further moves in the areas of capital requirements as well as stricter lending criteria.
However, despite the potential impact of both of these risks, the greatest potential threat to the banks is the housing cycle itself. If the housing cycle has peaked as some early data is indicating, then this materially impacts both bank revenues and costs. Revenue is compressed by slower credit growth and thinner margins as banks compete for customers. Costs are impacted by rising bad and doubtful debts (BDD) and provisioning for future debts.
Our current investment view on the banks
The latest set of results was very much in line with expectations and hence has minimal impact on our current assessment.
In short, we see that current bank valuations are at the top end of their historical range in terms of both price to book value and price to earnings, and some way above on a Price to Earnings Growth (PEG) basis. Given the position in both the housing and interest rate cycles, this would normally generate an outright sell.
Two factors that could drive banks higher
However, there are 2 factors that mitigate this view. The first of these is the likelihood of out of cycle rate rises, which will provide a partial earnings buffer.
The second is the ‘weight of money’. Exchange Traded Funds (ETFs) are growing rapidly and the big 4 banks represent 29.12% of the S&P ASX100 and a staggering 46.55% of the S&P ASX20. As many of the larger ETFs run on these types of indices, it means that either 1/3 to ½ of every dollar spent on an Aussie ETF is likely to find its way into one of the four banks. This is an emerging dynamic that can out-weigh valuations and underlying fundamentals.
We nonetheless remain underweight the banks, but are cognisant that these factors could see them trade higher.