What Next for Our Lumbering Banks?

Dear Reader,

No doubt about it, bank stocks make up a core part of many investors portfolios. There would be investors who have owned bank stocks for decades.

And even if you don’t own them directly, it’s almost impossible to conceive of a situation where you wouldn’t own them as part of your superannuation.

Unless you run your own Self-Managed Super Fund (SMSF), and choose not to own any bank stocks, you can safely assume that if you have superannuation, you own a swag of bank shares.

With financial services making up around 40% of the Australian market — 30% for the Big Four banks alone — bank stocks are a must have for fund managers.

If they are going to at least match the performance of the market, it is hard to do so without the biggest constituents of that market.

Not to mention the depth banks add to the market. With a collective value of around $385 billion, the Big Four absorb a large chunk of the funds that relentlessly flow into the market via managed funds.

It’s hard to imagine where all those billions of dollars would find a home, if they didn’t have some, if not a lot of it allocated to the bank sector.

Because of that, banks stocks are the most watched by analysts. Banks also give a good gauge to how the economy is fairing.

None more so than Australia’s largest bank (and stock), Commonwealth Bank of Australia [ASX:CBA].

As I wrote in last Monday’s (13 January) edition of The Rum Rebellion, CBA are scheduled to release their half-year results on 7 February — just two and a half weeks from today.

You can be sure the bean counters at CBA will be working around the clock to get the report done.

Within seconds of the result being released, banking analysts all over the country will be busily plugging the numbers into their spreadsheets.

Typically, the most important number the analysts first look for are the bank’s Net Interest Margin (NIM). Simply, the difference between what the bank borrows and lends at.

Whilst a good chunk of CBA’s funding comes from its own depositor base (usually 70%-plus), it still has to fund that other 30%. And that means, issuing bonds and shorter-term bills into the bond market — typically overseas.

Drilling into this second part of the funding — the overseas component — gives a good indication on how international investors price the risk of the Australian economy. More specifically, the housing market.

It is no secret the huge part housing, construction and property plays in the health of the Australian economy.

Like any borrower/lender relationship, the higher the perceived risk, the more interest a lender will want to receive.

Overseas pundits have often got it wrong with their calls on the Australian property market. They called it wrong as prices boomed for more than a decade straight.

A lot of the heat came out of the property market a couple of years ago. So too the premium bond holders wanted to receive to reflect the additional risk they perceive to be taking on. CBA’s funding costs have dropped in the last half of the 2019 financial year.

With the property market once again showing some life, it will be interesting to see if this overseas funding costs start to creep up.

The other big number is the number of loans in default or arrears. Perhaps surprisingly, this remained relatively stable when the property market ran out of puff.

The following chart shows CBA’s loan loss rate for the last decade.

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Source: CBA

[Click to open in a new window]

This number represents the percentage of CBA’s loan book, which it has expensed as a loan impairment. Note that the numbers are quoted in basis points, meaning last year’s 16 represents 0.16% of its loan book.

While still small, after rising to 0.16% from two years at just 0.15%, no prizes for guessing that this number will be closely scrutinised.

Of course, for income investors, while these numbers might be of interest, much more important will be the dividend they receive.

In recent history, CBA has only cut its dividend once — in 2009, right as the subprime disaster reached its zenith.

Since then, CBA has taken much pride in either increasing or matching its previous dividend. What it hasn’t had to do, unlike the other big three, is cut its dividend.

Nor like ANZ Banking Group [ASX:ANZ] shareholders, the ignominy of a cut in franking credits as well.

One thing you can be sure of — as sure as you can be, that is, with the markets — is whatever fate awaits CBA’s numbers, you can expect that to be similar, if not worse, with the other three big banks.

While CBA reports in February, we will have to wait another two months — around late April — to see how these others are performing.

The banks certainly got beaten around the heads in the royal commission. And their pain is still not over, although it is waning.

By the time they have paid out fines and reparations, they will each have torn up billions of dollars. Not to mention the time and extra staff they have had to employ to deal with the magnitude of the process.

Add in additional capital requirements as per Basel III, and you can see plenty of reasons why income investors might choose to give banks a wide berth.

Even with their share prices smashed (less so for CBA), the Big Four sit very comfortably in the largest 10 stocks on the ASX.

Yes, higher capital will mean lower return on equity. And tighter interest margins will also put the squeeze on profits.

However, bank stocks in Australia enjoy something that most other banks worldwide do not. They operate in a cosy market oligopoly.

They still enjoy margins on their products (like credit cards and foreign exchange) that make them the envy of their overseas counterparts.

Income investors and fund managers have already readied themselves for a world of smaller dividends from banks. The market’s expectations have been reset.

What investors might see is a surprise in future bank results, but this time to the upside. And once again, banks might hold unchallenged the mantle as Australia’s best dividend stocks.


Matt Hibbard,
Editor, The Rum Rebellion

PS: Forget about term deposits. In this report, Matt Hibbard shows you his top five dividend-paying picks for 2020. Click here to claim your copy today.

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