Investor optimism about banks misplaced

The rally in developed market bank share prices has resulted in Australian investors speculating that that vigorous growth in US and the end of easing in Europe will spillover to local lenders and drive prices sky high.

But the potential benefits for the major Australian banks are overstated, according to Morgan Stanley analyst, Richard Wiles, who argued that local bank prices are expensive.

Looking at the optimism in the global banking sector, Wiles noted that higher interest rates in the US point to better than expected margin expansion for many banks in the US and parts of Asia.

And, he agreed that the transition from negative interest rate policy to yield-curve targeting in Japan is beneficial for banks there. At the same time an end to easing in Europe - and an expectation that the European central bank will taper in 2017 - should allow European bank margins to bottom, possibly rising.

"However, we believe Australian banks are unlikely to benefit nearly as much given their different balance sheet structure and a less hawkish outlook for official cash rates," Wiles said. "Mortgage repricing should continue but it's already factored into our forecast of flattish margins in 2017."

On the capital front, a combination of delays to Basel IV reforms and the potential for less regulation in the US under the Trump administration has increased investor confidence in banks’ capital adequacy and dividend growth prospects.

As such, Morgan Stanley’s US bank expert is predicting an 8 per cent rise in 2018 Earnings-per-Share if banks fully optimise capital.

Stark contrast

Further, the firm's European team believes that a recalibrated, softer capital adequacy framework could support banks trading with high dividend yields and/or sharp discounts to book value due to capital concerns.

"In stark contrast, the capital build for Australian banks has been delayed and the prudential regulator has stated that capital accumulation remains the appropriate course," Wiles said. "At the same time, three of the major banks have acknowledged that payout ratios are above target levels.

“Accordingly, we don’t think Australian banks stand to benefit as much as many global banks from the prospect of less onerous capital requirements.”

But it is the Trump administration tax cuts from 35 per cent to 20 per cent that is buoying optimism about banks as large cap banks EPS could be boosted by 10 per cent.

"In Australia, we see little prospect of material upgrades from lower tax rates, as the government’s proposed reduction of the large company tax rate is long dated and currently looks unlikely to get through Parliament," Wiles observed.

Finally, since the US election, Wiles’ forecasts for developed market GDP growth have been upgraded as the ‘G10 surprise index’ surged to a six-year high. Yet in Australia, the forecast is for below-consensus growth of 2 per cent in 2017, as Canberra focuses on consolidating the budget.

"Accordingly, we think the revenue growth outlook for the Australian banks is likely to remain subdued, and loan losses are likely to move higher from current levels," he said.

Thus, in Wiles view, Australian bank trading multiples look elevated on several measures and he'd argue that the outlook for return on equity, EPS growth and dividend growth is less attractive than it was in the past.

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