By Paul Rickard 

Cast your mind back to February. Financial stocks were on the nose globally. In Australia, we followed suit and trashed the prices of the four major banks. The market was worried about a commodity slump causing havoc to bank balance sheets through exposures to troubled miners and mining service companies, expected capital demands and the possibility of dilutive capital raisings to accommodate the Basel IV regulatory framework, the prospect of dividend cuts and the banks being “ex-growth”.

Less than nine months later, and partly on the back of “Trumpomania”, four out of these five drivers have largely evaporated. The first driver, the lead from offshore markets, has really turned around. So far in November, which covers both pre and post the US election, the US S&P 500 Financials Index has added an astonishing 12.41%. In Europe, the STOXX 600 Banks index has returned 5.43%.  In Australia, our gains are more modest, up by just 4.22%.

No one is talking about the commodity price “slump”, and while dividend cuts haven’t quite gone away, they are pretty much factored in. ANZ did cut its dividend, while CBA, NAB and Westpac were able to hold their dividends unchanged. And while payout ratios for the latter two are touching 80%, there appears to be growing confidence that any dividend cut in FY17 will be modest, and more than likely, won’t occur until FY18, if at all.

The capital question

On the question of banks needing to increase their capital ratios and the impact of Basel IV, the Chairman of APRA, Wayne Byres, has put this on the backburner. Speaking last Friday at a conference in Melbourne, he said that “2017 will be a year of consultation. We don’t expect to have final standards before this time next year. And even if that is the case, they won’t take effect until at least a year after that”.

This means no bank capital raisings in 2017, and that the earliest that the banks would need to comply with any new capital standards is 2019. That doesn’t mean that the banks can take it easy, because he also went on to say that “capital accumulation remains the appropriate course for most ADIs (authorised deposit taking institutions)”.

However, each of the four major banks sits comfortably above their target capital ranges, generally considered to be a CET1 (common equity tier 1) ratio of between 8.75% and 9.25%. At 30 September, ANZ was at 9.6%, CBA 9.4%, NAB 9.77% and Westpac 9.5%. While these ratios will come down when the September balance date banks (ANZ, NAB and Westpac) pay their final dividend, and the target range will increase when APRA concludes its consultation process, the banks should be able to meet any new requirements through organic capital generation, dividend re-investment plans and the continued sale of non-core assets. “With sensible capital planning, the actual implementation of any changes should be able to be managed in an orderly fashion”, he said. 

Dilutive capital raisings are off the agenda.

That leaves us with “the banks are ex-growth”.

Are the banks ex-growth?

The banks are considered ex-growth for four reasons. Firstly, credit growth in the economy is low, running at an annualised rate of just 5.4% in the year to September.

Net interest margins have been under pressure, partly because of a change in funding sources and more emphasis on stable, longer-term retail funding, but mainly due to the very low interest rates. When the RBA reduces the cash rate and you are pressured to cut your lending rates, but can’t cut your deposit rates because you can’t cut a 0% or 0.01% deposit rate any further, margins get squeezed.

Next, there is the credit cycle, which is seen as at an historic low in terms of the losses banks have been booking. If losses are going to increase, this will reduce bank profits. Finally, if banks are increasing their capital base (either by issuing more shares via a DRP, or selling assets which in turn takes away revenue sources), it's extremely difficult to grow EPS (earnings per share).

Looking at the recent bank financial results, that’s exactly what happened. For all banks, the second-half profit was flat on the first half, full-year profit growth was low single digit, and year-on-year EPS growth was flat to negative.

But, does Trumpamania change this? Potentially, yes. Not with the credit cycle or an increasing capital base, but he could influence credit growth if he gets the US economy firing, companies start to invest again, and this spreads to Australia. More likely however, he is impacting the expectation that interest rates in the US will go up, which as the lead market, will influence Australian rates. Australian bank net interest margins could start to improve.

And even if our banks can’t do much to improve the revenue outcome, profit growth can come by cutting costs. Of course, the old adage goes that you can’t “shrink your way to greatness”, but do you really believe that our banks are lean and fighting fit? And with the kids now doing their banking on mobile apps, the imminent removal of cheques and the cashless society, think of the billions that can be saved when the banks start to wind down their branch networks.

I don’t buy the line that the banks are necessarily “ex-growth”.

Bank sector looks like value

According to FNArena, the banks are trading on forecast multiples ranging from 12.0 times to 14.0 times FY17 earnings, and 11.7 to 13.8 times FY18 earnings. Forecast dividend yields range from 6.5% to 5.5%, plus franking credits. These aren’t super cheap multiples, particularly compared to some banks offshore, but they are also not that high compared to the multiples they were trading at two years’ ago.

Importantly, most of the reasons to be negative about the sector have ameliorated.

I think the sector is in buy zone. Given the extraordinary run since Donald got the gig, it may need to pullback a little first, however I expect that this sector will outperform the market. If you want to see my views on the individual banks, you can read about this in the Switzer Super Report.

Disclosure: I and my family’s SMSF are shareholders in each of the four banks.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.