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Is bank bias worth the risk?

The 2015 Russell Investments/ASX Long-term Investing Report encouraged investors to stop relying on local investments and consider the full range of asset classes available. Given the ‘Big 4’ banks make up nearly 30% of the Australian share index, many investors are highly exposed to the sector. Australian shares themselves make up a significant proportion of most multi-asset portfolios, so even ‘diversified’ investors can find themselves with 10% of their investment in just four stocks. It’s time investors took steps to address this concentration of risk.

Australia leads the world in stock market bank domination. In contrast to Australia’s almost 30%, banks account for around 20% of the London Stock Exchange and 10% of the New York Stock Exchange.

Since bank profits have been driven by strong growth in mortgage lending, those who believe they are ‘diversifying’ by investing in local shares and local property actually have both of these choices hitched to the same wagon.

In recent years, that wagon has been rolling along just fine, with the major banks proving to be highly profitable and solidly-yielding stocks. Bank stock returns were strong in 2012 and 2013, as investors seeking both safety and yield pushed them higher. But then 2014 turned into a mixed year for returns, helping Australian equities to lag overseas markets for the second consecutive year. Now, in 2015, we’re seeing the banking sector falling, and taking the market with it.

Not surprisingly, some investors are starting to ask: are the wheels falling off?

Our answer is: not yet. The Reserve Bank of Australia is unlikely to raise interest rates any time soon, and may cut them. And the rumours that the tax review will lead to the removal of franking credits are in our view just that. However, looking ahead, investors need to understand the risk they are taking on if they persist in relying on the bank-dependent local share market.

Understanding the three layers of risk

Bank sectors contain three types of risk on a sliding scale from (1) superficial share-price volatility through to (3) deep-seated systemic risks that threaten the security of deposits.

  1. Share price volatility – regardless of the health of the institution and the security of depositors, bank stocks are relatively volatile in the current environment. We saw this when the 20% jumps in January and March 2015 were given back in April and May. However, we’re probably at the bottom of the current zigzag, so the immediate risk of further loss is relatively low.
  2. Bank capital impairment – the banking system seems incredibly calm at the moment, with the charge for bad and doubtful debts as a percentage of assets down at about 0.2%. However, investors need to take into account that banks are geared at 15:1 (as opposed to most non-financial blue chips, which are currently sitting at around 2:1). This means if the housing cycle turns down, or unemployment gets worse, any impact on bank asset values would have a 15-fold impact on shareholders’ equity. To make matters worse, these impacts on the share market rating of book values, and on the book values themselves, can compound. Easily imaginable events, such as a 15% fall in the price-to-book ratio of the banks and a 15% fall in the book values themselves, quickly add to a 30% drop in the portfolio value of bank stocks. All of a sudden, the banks have very little room for error.
  3. Another financial crisis – external economic shocks could rock the asset markets, destabilising consumer and business sentiment. For example, a savage bond default or a string of corporate collapses could trigger a correction in global credit markets. Although this type of meltdown is unlikely, we need to remember that it’s been nearly 25 years since Australian banks ran into serious issues. Our banking system collapses, in 1974 and 1991, were out of sync with the rest of the world, which took its turn in 1982 and 2008. Australian banks tend to have a major solvency crisis every 20-25 years. Our last one was in 1992 ...

Realistically, we believe investors need to focus on the first two layers of risk. Most will be able to live with the first one. But the second one, although probably only a medium-term risk, is a real issue, if only because of the number of factors that could go south. And remember, too, that there’s an earnings dimension to bank stock valuations. The big four Australian banks earn $30 billion a year between them. That $30 billion is currently highly valued by the market, as measured by bank price-to-earnings ratios. But, like the equity base of the banks, that earnings stream faces a range of threats.

Increasing areas of vulnerability

  • Housing market – Australian banks are exposed to one of the hottest housing markets on the planet, driven mainly by falling interest rates. But now, with almost nowhere left for rates to fall, that same level of capital appreciation is unlikely to be repeated. If, as ASIC believes, signs of dangerous property bubbles in Sydney and Melbourne are accurate, residential housing prices could conceivably slump in years to come. Some of the warning signs are already appearing: based upon NSW’s dwelling approval rate, for example, overbuilding may start to quench demand. If unemployment climbs, the housing market will be in trouble. With economists warning that the capital investment outlook has gone from ‘bleak’ to ‘recessionary’, it’s not a huge leap to imagine a number of other economic indicators worsening next year.
  • Government bonds – As the US Federal Reserve goes into a tightening cycle, we can expect turbulence and sell-offs in the US Treasury markets. If there are flow-on effects in Australian bonds, it won’t damage banks, but the rising yields certainly won’t help with the share market valuations of these yield-based securities.
  • Traditional margins – Bank reporting is pretty opaque when it comes to the real drivers of margins. However, we can make some well-educated guesses about where some meaningful chunks of the $30 billion come from. One likely candidate is credit card lending, with many billions of dollars borrowed by the banks for only 2 or 3%, and on-lent to undisciplined credit card holders at rates in the high teens. Another juicy source of profit is currency conversion, with uninformed customers, historically, being price-takers in the market. Both these profit sources are facing headwinds at present: credit card profits from a new-found consumer conservatism, post-GFC; and currency profits from enhanced transparency in an internet-age.
  • Disruptive technology – in a world run by smart phones and apps, the retail banking and home mortgage segments are ripe for disintermediation. Amazon, PayPal and Google are growing consumer payments, SocietyOne is pioneering peer-to-peer lending, new mortgage providers are taking market share with superior processes and savvy consumers looking for competitive pricing and product choices are cheering from the sidelines. At the same time, cybercrime, scams and hackers are defrauding Australians of millions every year and the banks are in many cases picking up the tab. In the process, both profits and confidence in bank security are being depleted.

Even without a crash, these headwinds are highly likely to reduce the performance of bank stocks for the next 5-10 years, causing the banks to drag on the Australian share market.

Revisit home country and bank bias

Domestic investments can continue to have a role in Australians’ portfolios, but investors with a home-country bias would do well to revisit their allocations; reduce their exposure to residential property and start investing a portion of their equity allocation offshore.

At the very least, they need to understand the percentage of their portfolio tied to the Big 4 banks and watch for the warning signs. If bond rates and unemployment continue to rise, and if the national housing market slows, that will be a shift from green to amber and a signal to rethink portfolios – before the rush gathers too much pace.

 

Graham Harman is a Senior Investment Strategist at Russell Investments. This article provides general information only and does not take into account your individual objectives, financial situation or needs.

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