Australia is decoupling from the global recovery, with consumers facing a cash flow and credit crunch, income growth has not recovered, 'cost of living' inflation is accelerating, and 'MacroPru' is broader than just housing.
Morgan Stanley banking analyst Richard Wiles says while credit quality was sound in the 2017 first half, pressure on consumer spending from falling incomes, cost of living inflation and credit rationing will affect business profitability and employment.
This economic backdrop exacerbates the problems for Australian banks, given a weaker domestic economic cycle, fundamental change in the mortgage market, and increased political and regulatory scrutiny, he told clients in a note.
Yet, surprisingly the big four banks are priced for 4 per cent loan growth, underlying margin expansion, loan losses of just 25 basis points and a mere 20-basis point lift in capital levels, the analyst pointed out.
"Despite total shareholder value being down an average of 12 per cent since April, major bank multiples remain above long-run averages," he noted.
The deteriorating outlook has prompted him to raise the likelihood of a ‘bear case' outcome, which assumes recessionary conditions in 2018 alongside a more material lift in capital requirements.
Bull and bear
The analyst's conviction that there is now a higher probability of a bear case outcome than a bull case scenario is underscored by APRA’s recent comments that suggest that "further strengthening" of capital is required.
“Our bear case factors in a meaningful slowdown in the Australian economy in 2017 and 2018 which results in slower loan growth, margin contraction of 10 basis points due to higher funding costs, and an increase in loan losses to 95 basis points of non-housing loans in 2018.”
Worse, he calculated, the bear case implies average downgrades of 16 per cent to Earnings-per-Share, 23 per cent to dividends and an average Return-on-Equity of 12 per cent in 2018.
“In such an environment, we believe the banks would de-rate to an average price-to-book value multiple of 1.3 times, down from 1.7 times currently, implying a 25 per cent drop in bank share prices.”
If this happens, Wiles would expect ANZ’ share price would take a 22 per cent dive and the Commonwealth Bank share price to drop by 37 per cent. National Australia Bank would fall by 25 per cent and Westpac by 26 per cent.
In his view, systemic risk is greater in Australia than in most other countries, given the concentrated bank sector, lack of diversity, "heightened risk" in the housing market, and heavy reliance on offshore funding.