A hidden tailwind for banks

I noted back in early 2013 that you couldn’t call a bank bubble at the bottom of the cycle. Recall at that time there was a view that banks were expensive and couldn’t run higher – UBS investment bank, in particular, had the view that banks were in bubble territory.

It’s been over a year since that call was made and, in that time, our bank stocks pushed up between 11% and 19% at the high. It’s fair to say that there’s been some retracement since.

Most of the big banks now, with the exception of Commonwealth Bank (CBA, which is still up 12% since May 2013) have flat lined, or range traded if you prefer.

Overall, the impression is that investors are cautious as it were – unwilling to take the banks much higher, but neither are they willing to sell. This isn’t necessarily a bank specific issue I have to admit, as our whole market has been pretty flat this year.

When it comes to the banks though, I can appreciate the source of this caution and Alan Kohler highlighted why some is warranted on the weekend. Indeed, Stocks in Value and John Abernethy have a sell on CBA, with a valuation around $71 (currently $81.1).

To generalise, investors are concerned that banks stocks have run too high on the back of the “hunt for yield” rather than genuine growth. Bears in the market regularly cite the looming issue of increased capital requirement along with fears around unemployment and borrowers’ overall ability to repay loans.

But, then again, earlier today CBA produced a full-year record result in line with expectations. The bank recorded a 12% year-on-year cash profit increase to $8.68 billion.

Within that framework, investors should be aware of one key area of macro support; namely, the turn in the credit cycle.

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Recall that back in 2013 credit growth was around 3% on an annual basis. Since that time, we’ve seen credit lift to an annual pace of 5% now. Still half what is normal, but the momentum is picking up.

Now most of this, as you’d already be aware, is housing driven. Total housing credit is up by 6.4% annually, split between investor credit growing at an annual clip of 8.7% and credit for owner occupiers at 5.3%. Those numbers are a little deceptive, however, as they seem to suggest that most of the pick-up in credit growth is investor driven. That’s not the case though. Two-thirds of credit goes to owner-occupiers, not investors, and of the lift in lending over the year more than half, again, went to owner occupiers.

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There are a few issues to note at this point. Firstly, and in terms of the longevity of the upswing, it’s almost irrelevant that first homebuyers are being priced out of the market. First homebuyers are not a large segment of the market. That’s not to say they are insignificant, but even at the low, existing home owners were still 70% of the market – the average is 80%. That existing home buyers are currently 88% of the market, a record high, isn’t too far out of whack given the historical average.

All we are witnessing is a shift in lending demographics as a result of government policy. This shouldn’t be expected to have any bearing on the strength or durability of the credit cycle.

Paradoxically, when the credit cycle weakened through 2011-2013 bank share prices lifted – this is not what they would typically do during credit soft patches. The issue now is, would they be necessarily buoyed when the credit cycle moves into higher gear.

That being the case, we should also note that this rebound in housing credit has a long way to run. Housing credit is still only half the average – that holds for investors and owner occupiers. Don’t forget that we shouldn’t buy into this argument that consumers are debt constrained either – they’re not. Debt-servicing ratios remain low, and well below the peak.

Perhaps one of the more important issues for bank revenues is that business credit is now turning. Business credit accounts for about one-third of total credit and is approximately 1.5 times the size of the housing investor market. As you can see from chart 3 below, credit to this segment has been extremely subdued, running at an average annual pace of only 2% this last year. That’s about 80% less than what’s normal.

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This has the potential to be a major revenue source for the banking sector going forward. Non-mining business investment is very low – there is ample scope for a marked uplift – a non-mining boom as it were. Certainly the non-financial business sector is well positioned for such an event, as you can see from chart 4. This shows that business has undergone a substantial deleveraging, such that debt as a ratio to GDP is back down to decade lows – 15% off its peaks. Debt servicing itself is the lowest in more than a decade.

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On that note we saw a positive development this week in the new lending figures. Commercial finance is surging, up 12% over the month to June alone – 30% for the year.