Australian banks continue to bewilder the northern hemisphere

The tale of the bank profit results and trading updates so far is retail banking is very healthy, business banking promises better but is yet to deliver and the credit cycle, almost incredibly, continues to defy sceptics.

Of course everything in banking is entwined – one of the reasons bad debt charges continue to improve is there hasn’t been a huge amount of commercial lending in recent years and, because economies are anaemic, interest rates remain historically low. And low rates result in fewer borrowers getting into repayment trouble.

Investors nevertheless have taken the numbers so far as reason enough to lighten their holdings. Bank share prices, as is often noted, are quite fully priced.

So banking in Australia and New Zealand is solid if unexciting - unless you’re in the northern hemisphere where this reporting season has been read as a harbinger of impending doom Downunder.

Take the Financial Times’ highly regarded Lex column. After the Commonwealth Bank reported what most considered another extremely strong result, Lex opined:

“Australia has not been in recession for 23 years. Stock in Commonwealth Bank of Australia changes hands at pricey 15 times forward earnings, with a market capitalisation of $122 billion. Joblessness is at a 12-year high. One of these numbers jars with the others.

“When the economy sours even owning a large, yieldy bank is, ultimately, still owning a bank whose earnings depend on credit growth.”

Central to Lex’s pessimism is the perennial fear Australia has too much debt in general and households have too much debt in particular – and too much of that is tied up in housing.

“No recessions in two decades means households (in Australia) never needed to adjust, as their UK or US counterparts did post-crisis,” Lex argued.

Lex of course is penned from the other side of the world where the financial crisis hit hardest. This view is not an on-the-ground one. (The "Sydney market" is a bit of a give away, Lex seems to think the chalkies are still running about the floors in separate Australian stock exchanges.)

Still the argument is far from fatuous. Many would agree it is difficult to see the bank index continuing its performance of the past three years when the ASX 200 banking index returned 94 per cent to the ASX 200’s 54 per cent.

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And the debt issue is a concern. However, a glance back at these charts used by the Reserve Bank shows analysis of debt prior to the financial crisis would not have been much help.  

Neither household debt nor gearing levels were a good signal as to what the crisis would bring.

Moreover, the RBA has undertaken several rounds of research into the structure of Australian debt and, for the moment at least, at the household level it is held by those who can afford it unlike the situation pre-crisis - in the US in particular where debt was concentrated in the hands of those who never had a hope of repaying it.

Both corporates and individuals in Australia have also been paying down debt. Australian corporates are at their lowest level of gearing for decades. Australian households have been actively deleveraging. Australian 'savings' are also predominantly held in the $1.4 trillion superannuation sector which is not typically adjusted for when international comparisons are made.

Across the mortgage books in Australian banking, more than half of all borrowers are ahead on their repayments. A sizeable percentage are six months or more ahead on payments. Repayments are running almost neck and neck with new mortgages being written.

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Another key difference is the issue of shadow banking. Some feel this is a maligned segment and should be known as 'market-based financing' but while it is a legitimate market it is also less transparent. America’s sub-prime mortgage debacle was fuelled by the fact so much lending was being traded, in complex forms, in markets and was not held on the balance sheets of banks.

Australia does not have this issue.

But Lex and others are right to question whether this is as good as it gets for the banking sector and from where will growth come?

Commonwealth Bank looks a true blue-chip: its return on equity is 18.7 per cent, earnings per share growth is around 12 per cent, its capital as measured by the more stringent rules of the Australian Prudential Regulation Authority is 9.3 per cent and on the measures accepted internationally 12.5 per cent.

Its well publicised financial advice problems aside, it is a very well managed company with a strong record of shareholder value creation.

But two things continue to characterise Australian banking: the strength in the retail and particular mortgage markets. And the continuing positive credit cycle.

There is little evidence the credit cycle is turning or will turn in the foreseeable future. Commonwealth Bank’s credit quality remained excellent, with just some particular problems rather than systemic ones. Its impairment charge was down 12 per cent on a year earlier.

ANZ’s chief financial officer Shayne Elliott told BlueNotes he could see nothing to spook the horses and write backs on debt previously written off continue to emerge, bringing the charge to profits down further. National Australia Bank’s update on Monday confirmed these trends.

But the challenge is revenue.

The two Sydney banks, Commonwealth and Westpac, have certainly benefited from being overweight houses compared with the more business skewed Melbourne banks in recent years.

In the Commonwealth result, retail banking was up 12 per cent but business banking just 4 per cent.

A rebound in business banking has been a long time coming yet it must certainly emerge if revenue is going to grow across the sector. For business oriented banks too proportionally more income is sourced from markets activity. Not betting the bank’s own book but undertaking activities like currency and interest rate hedging – which are far less in demand with low interest rates and little volatility.

ANZ’s Mike Smith was optimistic at the trading update about improving business conditions. So too NAB with its update.

Indeed, a range of economic data supports the view.

In the wake of the spike in unemployment, more buoyant readings from NAB’s Business Confidence and Business Conditions surveys supported Smith’s view business was ready to invest.

The July NAB Business Conditions number rose to +8 from June’s +2. Business Confidence rose to +11 from +8. Confidence rose to its highest level since September 2013, whilst the Conditions gauge rose to its best level since early 2010. NAB noted much of the improvement in Conditions came from three sectors: construction, manufacturing and wholesaling. Mining and retail were the weakest sectors.

Of particular note was the capacity utilisation data in the survey. This too supports the view business is starting to invest in capital intensive stock which will require funding at some point. The survey numbers were also supported by improving corporate sales and profitability.

Whether that translates to more employment – which is what everyone is obviously hoping and would suggest the unemployment numbers were a bit aberrant – is yet to be seen.

But if bank stocks in Australia are going to continue to defy the analysis from the northern hemisphere, it is not so much debt that is the worry but the lack of revenue. That is going to hinge on whether this time the improvement in business sentiment does translate. Over the past few years there have been no shortage of spikes to puncture the animal spirits of corporate Australia. The trouble is, whether politically or geopolitically, there’re still plenty of spikes on the road ahead.

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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