Banks are cheap for a reason

PORTFOLIO POINT: Bank share prices indicate the market is expecting higher bad debts and lower dividends.
The destruction of the global banking system that has dominated the world for the past two decades is creating great fear among world investors. Yet I would contend that recognising the losses and pulling apart the legacy institutions is part of the solution. No rescue package in any country will work unless there is a basic foundation: a solvent banking system.

Global bankers are concealing from their shareholders and the public, losses of between $US1000 billion and $US2000 billion. The effects of such hidden losses are mind-blowing and shaking the market. The exact amount of the losses is not known but the IMF estimates banking losses to be above $US2000 billion, while reported losses that have been covered by extra capital total only half that.

ANZ chief executive Mike Smith says the only way to solve the problem is to nationalise the insolvent global banks. It is certainly the simplest remedy but at the moment US, UK and European governments are toying with more complex but politically more palatable options such as dividing the problem banks into good and bad banks. That may work but it must amount to virtually the same as nationalisation.

In my view, the great risk to the stockmarket is not the destruction of the global banks but that politicians – particularly the US President – will not act decisively to remove the cancer in the system. The simple fact is that there is very little underlying equity value in groups like Citibank, Bank of America, AIG and the Royal Bank of Scotland. The sooner this is recognised by the market the better.

In a global situation of this magnitude everyone needs to make a call as to whether the destruction and/or delay in destruction will lead to a severe extended recession or, worse still, a depression. Our political leaders are working together much more effectively than they did in the 1930s and are determined to avoid a depression. If you think they will fail then of course the stockmarket fall has a long way to go; if they succeed – and I think they will – then there will be considerable value in global markets but it requires expertise to pick the right companies.

The Australian market has been caught up in the global panic but I think it is also signalling some nasty trends in our own local community. For example, bank shares priced at current levels indicate that the market expects much higher bad debts and lower dividends. In the middle management of our major banks there is now a deep fear of the looming level of problem loans among smaller businesses and individuals.

They can see loan stress signals that have not been evident since 1990, which will be triggered if there is a rise in unemployment. As a result, most of our banks are watching home loan payments very closely and are chasing extra security from smaller enterprises as they review their portfolio on a day-by-day basis. The pressure this is putting on enterprises is contributing to higher unemployment. And that pressure extends to larger companies. For Pacific Brands to shut Australian manufacturing of products made under its Bonds brand at this time was very dangerous for the future revenue from the company’s main income earner. The risk was taken partly because of pressure from the banks.

If those bad debts do not eventuate then the banks will be incredibly cheap. If they do occur then investors need to determine whether to buy banks now or wait for the writedowns. In the current market it is usually best to wait for the bad news because no matter how much anticipation takes place, when bad news is announced shares fall further.

There will be many investors who will continue to nibble at our leading banks stocks on the way down. It is possible we are now seeing the selloff we need to form a market base. A safe course is to conserve capital until the market has risen 20% and stayed at the high level for at least two months. You wont pick the bottom that way but that philosophy has avoided a series of dead cat bounces, which have ravaged so many investors during the past 12 months.

Although our bank bad debts may rise, our total banking system has nowhere near as much pressure on it as that being experienced in Europe and the US. Our banking system does not need to be rescued and that represents Australia’s greatest asset. In time it will be reflected in our stockmarket and the value of our dollar.

The stockmarket is also signalling that there is going to be a big fall in property values because there is no longer the lending capacity to support the old values. Premium property groups like Westfield value their properties on the basis of a willing buyer and willing seller so as to avoid “forced sale values”. We are going to see a dramatic withdrawal of overseas banks from property, infrastructure and business financing.

The major banks are confident they can fill the gap but if they can’t the “Rudd Bank” is set up to fund commercial property and avoid fire sales. Many banks say that the fall in domestic demand for loans will make it much easier for them to fill the gap left by departing foreign banks. Nevertheless, longer term there will be less funding available for commercial properties so prices will fall.

The stockmarket is pricing stock in anticipation of a major selloff, which the property industry and the government want to avoid. The general belief is that this downturn will last until well into 2010. If that is right then Westfield and the other shopping centre owners will have a difficult time because it will affect the revenue of their retail tenants.

Diversification of geography and tenants tends to insulate Westfield from normal fluctuations in retail demand but if, as is expected, the downturn is prolonged then retail sales in all shopping centres will be affected. In that environment property prices will come down, which may spook that market even though the fall has been well anticipated.

One of the forces that is hammering both the Australian stockmarket and the Australian dollar is the depth of the downturn in China, which is greater than anyone expected. Australia is vertically integrated into China. Of all the rescue packages that have so far been announced, the Chinese is probably the best and should start to stimulate demand for resources towards the end of 2009.

The Chinese take a much longer-term view of industrial development than is common in Australia. They know that in a few years mineral demand is likely to be much stronger and prices much higher. That is why they are anxious to buy as many top mining assets as they can when their prices are depressed.

They are seeking OZ Minerals, a joint deal with Fortescue and a major play in Rio Tinto. The biggest of these plays is of course Rio Tinto. If no other proposal is put on the table, then Rio Tinto’s high debt means that it will suffer badly if the Chinese bid is rejected by shareholders or by the Australian government under foreign investment rules.

However if the Rio deal is accepted by the government and the share owners it will put BHP on the back foot because the Chinese will almost certainly favour Rio Tinto and may increase production to keep a lid on prices of iron ore and other minerals. If the deal goes through I would sell BHP shares and buy Rio Tinto. If it doesn’t, then the reverse strategy would apply.

This is a time when really good companies seek to cement their position in the market. For example, during the early 1990s NAB took advantage of the weakness of its rivals to gain market leadership. Here are some of the opportunities:

• BHP needs to use its balance sheet to buy cheap assets but the manoeuvrings in Rio Tinto could cause it miss out altogether.
• In the retail space, Woolworths is attempting to lift its market share at the expense of Coles and Metcash. If it succeeds it will cement retail leadership in Australia.
• Health is insulated from the downturn. CSL is one of our most outstanding companies and plans to expand despite the tough times.
• Some building companies will do well given the rise in demand for insulation and the lower priced infrastructure projects.