Investors love Australia banks due to the income protection it provides. Australian banks, mostly consist of the big four Australian Banks make up the latest sector in the ASX 200. We are bearish on Australian banks because these are just leveraged play on the broader economy. Sector specific and broader macro risks on the horizon means it is very unattractive to own the banks. The number of reasons are listed below.
Higher capital requirements dilutive to ROE
It’s well known Australian banks will need more capital. Interesting article on the ball park figure required to be raised from shareholder in 2015.
For owners of Australian bank shares, the question is not on the cost of funding which is still extremely cheap. The focus should be on return on equity as the result of potential higher capital requirements.Greater amount of capital raised means it will put pressure on return on equity from 2016 onward.
Banks at its peak traded on two times it’s book value. With a teen level ROE, investors are getting sub 10% return on market equity. Given the risk in these banks, the reward from attractive dividend yields with franking credit does not offset the decline in the share price.
Peak cycle earnings
Current strong earnings is what you would expect from a booming residential real estate market. Cyclical stocks are cheapest at the peak of the cycle as investor discounts future decline in earnings.
Most recent earning reports shows record low level of provision for bad debt. ANZ coming out with a credit downgrade did not help sector sentiment or the ANZ bank share price. We see upside risk in this front on future earnings which will drag overall net cash profit.
Regulatory pressure on loan book growth
Australian regulators have pressured banks to slow investor mortgage lending. This is due to potential risk of housing bubble in the Australia residential market.
Residential mortgages is one of the largest component of bank loan book. Downside risk is magnified due to the leverage nature of borrowing short and lending long.
Charts below shows the median house prices of Melbourne and Sydney compared with the RBA cash rate. What is undeniable is that the run up in house prices is coupled with surging investment credit and declining cash rate. We think the current cycle is near its peak and further price gains does not compensate for the risk of real estate exposure.
The main catalyst for further deterioration of Australian bank loan books would be job losses. So far the only state showing weakness in housing and employment losses is Western Australia.
The market has turned for bank shares. Investors are tempted for bottom fishing however with weak job growth and consumer sentiment is weaker. Sentiment have to pick up before we are interested again in owning bank shares.
2016 Bank Share Price Performance
Chart below shows the year to date return of the four largest Australian Banks.