Markets: Will the banks justify their prices?

Bendigo and Adelaide Bank’s full-year cash profit jump of 7.7 per cent reflects one reason why domestic investors have been so enamoured of the financial sector, but Australian banks are trading significantly above their American peers who are entering a growth phase compared with Australia's more muted outlook.

The bank’s presentation showed that its retail mortgage lending growth rate of 6.5 per cent trailed only that of the National Australia Bank in the past financial year, and beat average mortgage lending growth of 4.8 per cent. Since the June lows, Bendigo’s shares have rallied 14 per cent, slightly outpacing the S&P/ASX 200 Financials index gain of 13 per cent.

Australian investors have long favoured investing in our domestic financial institutions, including banks and property trusts. The financial sector now makes up 44 per cent of the market capitalisation of the S&P/ASX 200, and a one per cent move by Australia’s largest company and bank, Commonwealth Bank of Australia (CBA), equates to around four index points.

Since reaching lows in March of 2009, the ASX 200 has gained 60 per cent, trailing well behind the US S&P 500 index, which has surged 142 per cent to hit fresh highs.

Financials for both indexes have dominated the recovery, leading their respective indexes higher. Australian financials, including some of the world’s highest-rated banks globally, have gained 98 per cent, but that is still well short of the S&P 500 financials which have climbed 225 per cent. Admittedly US financials were rising from a low base, but their recovery is nothing but spectacular and coincides with an accelerating recovery in the US housing market.

Interestingly, the current valuation measures for both financial indexes are distinctly different. Australian-based financials are currently trading around 16 times earnings, against their US peers of just over 13 times earnings. The higher local valuation is partly offset by a higher dividend yield on offer, but it is beginning to indicate that, in the absence of increasing earnings, current share prices do not warrant current valuations. In other words, they are expensive especially against their American peers.

US financials have benefited from a recovering property market, encouraged by record low long-term interest rates. Mortgage lending has been a beneficiary of this – second-quarter earnings from the US market show that mortgage banking contributed between 7 and 13 per cent of revenues for the top retail banks. Overall, earnings grew over 5 per cent for the quarter.

Australian banks will need prevailing record low interest rates to further spur the property market and boost mortgage lending. Historically there has been a link between rising house prices and mortgage lending, which if it continues will help Australian banks expand their mortgage lending and revenues. Bankers themselves are playing down the outlook, with Ian Narev last week stating that he sees clear risks to the downside (Why cash-filled Commonwealth is hedging its bets, 14 August).

It is only recently that Australia has enjoyed fresh lows in official interest rates, so the domestic environment is conducive to borrowing. If Australian banks can follow their US counterparts who have seen record low rates turn into higher house prices and larger mortgages, they should benefit, providing they can manage other aspects of their business.