Banks: how the new regime affects you

PORTFOLIO POINT: A change in Australian bank lending practices will affect everything from property prices to profit margins in the years ahead, with significant implications for investors.

Australia is undergoing one of the biggest landscape changes we have seen for many decades. We are all familiar with the two-speed economy and the division between mining and non-mining Australia. But the change goes much deeper than this.

In the last week or so, I have had the opportunity to talk to a number of corporate and political leaders, which has informed my understanding of this change, along with an important contribution from Morgan Stanley’s Gerard Minack, published earlier this week in Eureka. So I want to paint a picture of what I see happening in important areas of Australia, and examine the investment implications.

Like all predictions, it may be wrong, but I think there is a very good chance that the basic directions I paint for Eureka readers this week will prove to be on the right track.

I first want to take you back to the decades since the seventies. Banks have been an enormous engine of growth, because in most years their lending expanded strongly and, despite a few interruptions, their strong lending patterns led to growth in asset prices – particularly in the residential sector.

At least for the next half-decade, and perhaps for much longer, I think that era is over. Previously, interruptions to lending growth came as a result of sharp contractions in the economy and bad debts. That could happen this time around, but that is not what I am predicting. Banks grew their lending books because they had an unlimited supply of funds. They were not restrained by the local deposit market and they could go offshore and borrow as much money as they wanted, most of it at lower cost than local deposits.

That changed during the global financial crisis and for a time, the banks couldn’t get access to wholesale overseas money. With the help of the government guarantee, the overseas funding tap was turned back on and we probably didn’t recognise the significance of that event. But then in the middle of the latest European crisis, the tap was turned off again and it was clear that Australian banks cannot rely on wholesale overseas money for the core of their deposits.

So the banks must go out there and raise a great deal more local deposits. In years gone by, overseas deposits represented half (and sometimes even more) of the local deposit base. Local deposits are now around 60% to 65% of the base and they are headed to 70% and then 80%. The local deposit base has limitations and many potential bank depositors have their money in the sharemarket or with hybrids.

The reality is that banks will not be able to lower rates substantially and increase their deposit base at the same time.

Many overseas lenders to Australian banks are frightened at the level of exposure to the housing market in Australia, and believe that not only is it not sustainable, but that a crash is likely. I don’t think they are right, but the existence of that fear among such an important part of the Australian bank depositor base locks in the strategy of moving to 80% local funding for our banks.

In recent times, it has been relatively easy for banks to increase their business funding locally, because the demand for credit has been restrained. But the simple fact is that if there was a rise in local credit demand, the banks would struggle to meet it, unless they are once again prepared to punt the overseas market.

So we are headed into an environment where bank credit will be available, but it will not be abundant and it will not be cheap. As a result, the deleveraging process in Australia, which is part of the world pattern, has quite a way to go.

So what does that mean for the investment community? First of all, it means house prices overall are unlikely to have a boom period in the next five years. Some areas will do well; others will do poorly. Individual houses may do particularly well or particularly badly. However, it is always sound policy to own a house, because it is essential to your living and often housing jumps when you least expect it. Accordingly, it’s a safeguard; some people own a dwelling as an investment and rent the property they live in. That strategy is fine if it suits your lifestyle.

Those who own a house and are looking to buy investment homes may pick up some very good bargains in this environment, because there will be forced selling. But overall, it is a market that will need some care and understanding. There is no need to rush into it, and investors should not over-borrow to buy an investment property as you might do in a boom.

I agree with Monique Sasson Wakelin, who says inner-city properties will perform much better than those on the outer fringes. Consumer spending will be restrained, partly because of deleveraging and because we are looking at power price rises of between 35% and 40% between 2010-11 and 2012-13. In addition, both state and federal governments are looking to balance their budgets, so a series of nasty measures are ahead. A large number of companies are going to re-engineer their operations, which will involve labour shedding, particularly in back offices.

We are not going to see a return to boom-time consumer spending, given all these forces.

The banks have become nervous about big segments of the retail industry in Australia, and we are going to see a contraction of lending to retailers. If you have shares in a retailer with large borrowings, be careful – they will need to be very good operators. The non-mining growth areas for the market are going to be in health, personal services, telecommunications and areas of the internet. Banks will also be looking carefully at the position of manufacturers, but are planning to lift their lending to miners. They need to be careful, because I agree with Minack that over time, our terms of trade (read commodity prices) are going to gradually slip back. High-cost producers will suffer.

Nevertheless, provided there isn’t a housing collapse, this will not be a bad time for bankers, because most banks are dedicated to maintaining or increasing margins. Bank profits will not grow dramatically as they have in the past, but the shares will provide a strong yield.

Companies like Telstra are also extraordinarily well-placed, especially if their management is up to the change, and I think it is.

So how do you allocate your funds in this sort of environment? Bruce Brammall (Guarding super’s panic button, March 21) points to the theory that the percentage of interest-bearing securities in your portfolio should equal your age. So if you are aged 50, your percentage equity should be 50% and interest-bearing securities should also be 50%. At 60, your allocation should be 40% equity and 60% interest-bearing securities, and so on – both backwards and forwards. That is certainly a benchmark to think about and I will return to this subject. The trouble with most people investing in interest-bearing securities is that they use short-term bank deposits, which make them vulnerable to short-term interest rate reductions.

I think we are going to have more competition for longer term bank deposits. Another feature of this market is that banks want to issue hybrids before June 30, because they gain special grandfather status under the new global banking rules. After June 30, the number of hybrid issues will fall. I think a worthwhile component of interest-bearing securities and big-four bank hybrids makes a lot of sense in this environment (although don’t go overboard), but investors should spread their major bank hybrids around.

We will be watching the consequences of this change in the Australian landscape as the year rolls on.