Warning: there might be bank pain ahead

Warning: there might be bank pain ahead

Since early November 2016, owners of Australian bank shares have been heartened to see stock prices rise sharply.  But this could be as good as it gets – at least for a while – and it may be time for shareholders to take some profits and seek out opportunities in over-sold small and midcap companies.

An examination of the declining three year AA rated bond yield since 2012 reveals that mortgage rates have been in lock step.  Unfortunately, since the middle of 2016 those bond rates have been rising, which means mortgage rates are about to rise too.

With Australia’s mortgage debt and household debt-to-GDP ratios the highest in the world, it should come as no surprise that Australians can least afford increases in their mortgage interest rates now. Financial stress is increased when record high levels of debt meet with rising interest rates.

Of course if apartment investors are able to raise rents, they could offset the increase in interest rates on their mortgages.  But can they?  The answer to that lies in the experience of Brisbane.  For the nine months to September last year, over 5,200 apartments were completed within 5kms of the Brisbane CBD.  During the same period of time, owners of apartments 5kms to 15kms from the CBD experienced a doubling of vacancy rates from 2.3% to 4.7%.  So think about that for moment; just 5,200 apartments caused a doubling of vacancy rates.  What do you think might happen when the 13,000 apartments currently under construction and due for completion in the next 18 months hit the market?

It might not be unreasonable to expect a significant increase in vacancy rates as well as a rise in mortgage interest rates.  What is the yield on an apartment with no tenant?  Zero! Financial stress anyone?

The impact on investor appetite for apartments will be set back by these developments crimping the growth of every bank’s loan book.  On top of that, residential construction is about to hit a wall.  In October, apartment approvals dropped by 23 per cent.  Approvals lead to commencements, commencements to construction and construction to completion.  A drop in approvals is ultimately a drop in construction.  That’s another nail in the coffin of bank loan growth.

Without loan growth, banks need to rely on other means to provide shareholders with increased earnings.  One way they can do that is by reducing their allocation to bad and doubtful debts.  Unfortunately, they’ve already been doing that for years and as a result they actually need to build these provisions back up, which reduces profits.  Given the scenario above, it is likely non-performing loans will climb anyway, forcing them to accelerate the process.

Meanwhile, record credit card debt limits the ability to grow consumer loans and David Murray’s Financial System Enquiry saw APRA (Australia Prudential Regulation Authority) require the banks to increase their common tier 1 equity and reduce their mortgage risk weighting ratios, which means more capital and a lower level of leverage on that capital.  The end result of course is that returns on the banks’ equity will be reduced.

All of the above conspires against the banks being the most attractive investment option for share market participants.  Of course there is a price at which they are extremely attractive for investors with a 15 or 20-year horizon – remember the population of Australia is growing and eventually it will double, ensuring the banks make a lot more money.  But today bank prices seem to be reflecting an outlook that does not consider the possibility of disappointment.

If you own shares in the banks and are thinking about where to invest your profits, it would be wise to ask your adviser to reveal to you the small and midcap companies that late last year fell as much as 50 per cent while the banks rose.  Value investors might rejoice at being able to sell banks at the highs and buy high quality small growth companies at relative lows.

This article first appeared in Professional Planner magazine. You can read other Montgomery contributed articles here. 

MORE BY RogerINVEST WITH MONTGOMERY

Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.