By Samuel Subramaniam
Australia’s infatuation with dividends during the 90s and 00s has led to bank shares becoming a favourite for the retail investor. However, over the past few months, the nature of both the economy and bank shares have changed drastically.
The Economic Outlook and its implications on Lenders
Last Tuesday, the RBA decided to keep cash rates on hold at its all-time low 25 basis points. The Governor of the RBA Philip Lowe owed this decision to a “very difficult period and considerable uncertainty about the outlook” of the Australian economy. The Board considered a range of scenarios, with the baseline being a fall in output by around 6 per cent over the year as a whole.
In response, the Federal Government has injected about $320 billion into the economy with three stimulus packages based on supporting households and businesses. The International Monetary Fund’s prediction of V-shaped recovery has forecasted a year worse than the GFC. As the pulse of the economy, our lenders have and will face the brunt of these economic effects primarily through increasing impairment provisions (see figure 1).
Source: Macquarie Research
The Dividend Attraction
The Australian Prudential Regulatory Authority, in early April, urged the big four to “conserve capital” and make “prudent reductions in dividends”. In response to APRA’s recommendation and the worsened earnings outlook, ANZ and Westpac made the responsible decision to defer their dividend entirely. As seen in figure 2, payout ratios have fallen steeply.
As a key criterion for the conservative portfolio, high dividend payouts can act as a hedge against the increases and decreases in share prices, and further as a hedge against inflation in the long term. Carrying heavy weightings in indices including the ASX200 (nearly 20%) and the All Ordinaries, the big four have an authoritative role in the performance of index funds. Thus, one of the very reasons shares in these firms were attractive for retail, superannuation and index funds is buried.
Implications for Lenders
ANZ and Westpac, being the most exposed of the big four to institutional lending, have particularly faced a damaging first half of 2020, with cash earnings falling by 60.4% and 70% respectively (See figure 2).
It should be noted that CBA held its dividend in the interim; at the time, CEO Matt Comyn, whilst acknowledging the first half hit by the drought, bushfires and the coronavirus, was optimistic that the economy would bounce back in the back half of the year. Analysts have predicted a share buyback in the near future, citing Comyn’s comments regarding CBA’s excess capital creating “flexibility for future capital management initiatives.” The Commonwealth Bank will be the last bank to release its Q3 earnings this Wednesday (13 May, 2020).
Credit Ratings Agency Fitch has taken a pessimistic view to the near future of the Australian banks, downgrading long-term issuer default rating from AA+ to A-. This is still investment grade, but a downgrade nevertheless. Fitch cites their baseline case with further downside risk, citing the expected macroeconomic outlook, consisting of shrinking output and unemployment and the consequently affected asset quality.
From Dividend cuts to Capital Raisings
Nevertheless, amidst the crisis, NAB CEO of one-year Ross McEwan, has decided now is a good time to restructure. Amidst his crusade for cultural change since the findings of Hayne’s Royal Commission McEwan announced a capital raise of $3.5 billion at the lowest price NAB shares have been for two decades. Investors faced the double jab of the dividend reduction and capital dilution. While some have found this move distasteful, McEwan called it a “Balancing act” in utilising different levers to balance the short-term stability of the bank with his long-term vision.
WHY SHOULD WE BE OPTIMISTIC?
Liquidity Strength and Capital Strength
Although there is much pessimism, optimism prevails in certain market areas too. Colin Heath, PwC’s banking and capital markets leader, cites the strength of the CET1 (The average common equity tier 1) capital ratio, which stress tests the bank’s capital against its assets. Coming out of the GFC, the Basel Committee reformed a set of international standards to prevent a repeat of history, with one of these standards being to meet a CET1 of 4.50% by 2019.
To put the banks’ liquidity into perspective, the current CET1 is at 10.9 per cent. Deloitte banking and capital markets partner Steven Cunico takes the same view, “The banks are in a strong position. Liquidity is not and won’t become an issue, and capital is strong.” The wide held belief in the financial services sector is that the banks are well capitalised and will be able to absorb the impact of what may come.
Perhaps, there will be a quick rebound, and the V-shaped recovery hypothesis will be true, and this time next year, dividends will rise to the levels they were mere weeks ago. Maybe, we are even on the right side of the V. Over the past month the ASX has seen both bullish days and bearish days – waves of optimism and pessimism. Just this week, the ASX Financial index rose approximately 4.00%. The general sentiment in the market is that we have seen the worst of the virus, and the market is confident in the ability of our economy to recover quickly from the effects of CoVid-19.
Where to from here?
The fact of the matter is, how the big four deal with this crisis will determine the trajectory of the culture of the financial services industry over the 2020s. In terms of investing in bank shares, there is much uncertainty surrounding the equity market in general, but for now, banking shares are no longer the typical go-to for retail investors.
The blue-chip shares have re-based due to the dividend cut, and it may only be a matter of time until things return to as they were. From dividend deferments to capital raisings, the global health crisis we now face has transformed the global outlook in virtually every sector. Will we ever see payout ratios of 98% again? Perhaps, but for now, the nature of the bank share is very different from the one previously thought.
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Disclaimer: The views expressed in this article are solely that of the author’s, and do not necessarily reflect the position of UNIT nor the University of Melbourne. The advice given is general in nature and does not consider an individual’s personal financial circumstance. Transacting off this information is done so at one’s own risk, and individuals are encouraged to consult a finance professional before making investment decisions based off of this article.