Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 108

Don’t treat bank shares as defensive assets

Residential property constitutes by far the largest asset class in Australia, and on average, property accounts for over two-thirds of Australian households’ net worth. If you include investment in the bank shares, which are themselves heavily exposed to property, the average Australian household has about 70% of its net worth ‘at risk’ exposure to residential property.

What does this mean for the share market?

Various commentators have recently warned that the market valuations of the four major domestic banks are high. But instead of analysing P/E multiples, low credit losses or high payout ratios, in this article we apply a ‘big picture’ outside view of the banks.

Australian banks have been outstanding performers from both a revenue and share price perspective. Currently all four major Australian banks (ANZ, Commonwealth, National Australia Bank, Westpac) are among the largest 14 banks in the world by market capitalisation, which is extraordinary given that no German, French, Italian, or domestic British bank is in that top 14. There is one Japanese bank in the top 14, whereas 25 years ago, when the Japanese property bubble was at its peak, nine out of the top ten banks were Japanese. This is not just a question of market concentration — the entire Japanese banking sector value is 20% less than the big four Australian banks together.

Another useful comparison across countries and history is the size of the banking sector relative to the value of all the other listed companies in (Figure 1).

Figure 1:

The Japanese banking sector accounted for just above 20% of the market at the 1990 peak of the Japanese debt and property bubble. A similar level of 20% was reached by the UK banking sector at the peak of the pre-global financial crisis boom in the 2000s (though this was enhanced by non-domestic banks, such as HSBC and Standard Chartered, being listed in London). The index weight of Australian domestic banks is over 30%, a level not even reached during lending and property bubbles in markets overseas. It seems reasonable that the value of a nation’s (listed) bank sector should bear some relationship to the value of its (listed) national economy. Across the world this ratio is about 1:10; in Australia it is 1:2.

Australian banks do well because there is a lot of debt

Why are Australian banks so highly valued? Put simply, Australian banks earn very high profits. However, this is not because, in our view, they are better run, enjoy better margins, or use more advanced technology, but because there is a lot of debt in Australia. This debt is effectively the top line of a bank’s P&L — the more debt, the more net interest and fee income.

Figure 2:

This relationship is illustrated by Figure 2, which shows financial sector profits (which are dominated by banks) relative to GDP and outstanding credit to GDP. As both quantities are expressed as a percentage of GDP, one might expect a steady ratio. Instead we find that since the late 1950s credit has grown about five fold relative to GDP and so have financial sector profits. In this sense the high valuations of Australian banks have been driven by the same drivers as in the United Kingdom before the global financial crisis, and in Japan before the bust.

Figure 3:

The household sector has primarily been responsible for this growth in debt, as individuals have increased borrowing to purchase residential property. Figure 3 shows the household debt to income ratio over time for the United States and Australia. We note three features of these developments. Australian household gearing, previously much more conservative than that in the United States, rose very rapidly between 1990 and 2008 and exceeded US debt levels. US households have de-geared since 2008 while Australian households have not, and indeed the latest data show new record highs in Australia. The gap to the United States has thus widened further.

This data is not encouraging, but we note that there have been some positive lessons learned from the US crisis. ‘Low-doc’ lending, which the banks were just ramping up in the lead-up to 2008, seems to have mostly disappeared, liquidity levels at the banks have improved dramatically, and regulators have insisted on them holding significantly more capital. This does help but to what extent, if the lending and speculative investing continue unchecked? One is inevitably reminded of George Santayana’s well-known aphorism that ‘those who do not learn from history are condemned to repeat it.’

What to do?

These risks are real, in our view, but we do not know when and how these distortions will be remedied. We are more confident that, in a decade hence, this distortion will be obvious, like so many others before it. In the meantime, however, we face difficult choices. Given the uncertainties, and in particular our lack of information about the timing of any adjustment, how can investors sensibly and prudently proceed?

We describe two actions that can be taken within the context of the Australian stock market:

  • Investors around the world have sought out stocks with sound yields and defensive earnings, focusing on the utility, infrastructure, health care, and telecommunications sectors. However, in Australia (and only in Australia, it seems), this focus has included banks. Given their gearing and exposure to the domestic economy, we do not subscribe to this local view of banks as defensives.

    In our view, however, there are genuine defensives within the Australian market, in the sense that a sharp economic downturn would affect such companies less. These companies may have their own idiosyncratic problems at times, but they can mitigate macro-economic sensitivity within a portfolio. In our view, not all yields are created equal and some are safer than others.

  • There are, furthermore, successful Australian companies that have expanded globally and now run competitive businesses offshore or export to other nations. These companies can act as hedges to the Australian residential/bank exposure because a decline in the Australian dollar, lower wage growth, and spare capacity in Australia would raise the value of these companies. We believe the value of these companies would be enhanced in local currency in the event of a recession finally ending Australia’s remarkable run of 24 years without a downturn and its associated 24-year run of increasing household leverage.

In closing, we would like to stress that we are not predicting an imminent crash in Australian property prices. However, investors should be aware of the enormous exposure Australians have to this risk and that property and banks are likely to be highly correlated in any downturn. And while we can’t predict when these market distortions will start to unwind, we suggest that investors consider treating banks less like defensive holdings and consider domestic companies with global exposure in their portfolios.

 

Dr Philipp Hofflin is a Portfolio Manager at Lazard Asset Management. This article is general information and does not address the personal needs of any individual. This article is an extract from the longer version and is reproduced with permission.

 


 

Leave a Comment:

     

RELATED ARTICLES

10 reasons not to hold bank royal commission

Is bank bias worth the risk?

Who gets the gold stars this bank reporting season?

banner

Most viewed in recent weeks

Vale Graham Hand

It’s with heavy hearts that we announce Firstlinks’ co-founder and former Managing Editor, Graham Hand, has died aged 66. Graham was a legendary figure in the finance industry and here are three tributes to him.

Warren Buffett is preparing for a bear market. Should you?

Berkshire Hathaway’s third quarter earnings update reveals Buffett is selling stocks and building record cash reserves. Here’s a look at his track record in calling market tops and whether you should follow his lead and dial down risk.

Welcome to Firstlinks Edition 583 with weekend update

Investing guru Howard Marks says he had two epiphanies while visiting Australia recently: the two major asset classes aren’t what you think they are, and one key decision matters above all else when building portfolios.

  • 24 October 2024

A big win for bank customers against scammers

A recent ruling from The Australian Financial Complaints Authority may herald a new era for financial scams. For the first time, a bank is being forced to reimburse a customer for the amount they were scammed.

The gentle art of death cleaning

Most of us don't want to think about death. But there is a compelling reason why we do need to plan ahead, and that's because leaving our loved ones with a mess - financial or otherwise - is not how we want them to remember us.

Why has nothing worked to fix Australia's housing mess?

Why has a succession of inquiries and reports, along with a plethora of academic papers, not led to effective action to improve housing affordability? Because the work has been aimless and unsupported by a national consensus.

Latest Updates

90% of housing is unaffordable for average Australians

A new report shows that only 10% of the housing market is genuinely affordable for the median income family, and that drops to 0% for those on low incomes. This may be positive for the apartment market though.

Taxpayers betrayed by Future Fund debacle

The Future Fund's original purpose was to meet the unfunded liabilities of Commonwealth defined benefit schemes. These liabilities have ballooned to an estimated $290 billion and taxpayers continue to be treated like fools.

Property

The net benefit of living in Australia’s cities has fallen dramatically

Rising urban housing costs in Australia are outpacing wage growth, particularly in cities like Sydney and Melbourne. This is leading to an exodus of workers, especially in their 30s, from cities to regions. 

Shares

Fending off short sellers and gaining conviction in a stock

Taking the path less travelled led to a remarkable return from this small-cap. Here is the inside track on how our investment unfolded, and why we don't think the story has finished yet.

Planning

The nuts and bolts of testamentary trusts

Unlike family trusts, testamentary trusts are activated posthumously, empowering you to exert post-death control over your assets. Learn how testamentary trusts offer unique benefits and protective measures.

Investing

The US market outlook is more nuanced than it seems

Investors are getting back to business after a tumultuous election year. Weighing up the fundamentals is complicated, however, by policy crosscurrents that splinter the outlook in several industries.

Investing

Book and podcast recommendations for the summer

Dive into these recommendations for your summer reading and listening. Uncover the genius behind a secretive hedge fund, debunk healthcare myths, and explore the Cuban Missile Crisis in gripping detail.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.