It was a timely coincidence that UBS’ Jonathon Mott ignited a debate about Australian bank share prices even as the US Federal Reserve Board’s Open Market Committee was releasing its latest statement on US monetary policy.
Mott has caused a stir by making a case that the Australian banks’ share prices may be in 'bubble' territory. Notwithstanding the strength of the banks and their status as arguably among the strongest collections of banks in the world, he argued that their record price-earnings ratios are inconsistent with the low-growth and still risk-laden environment in which they are operating.
Others point to the less risky funding and asset bases and increased dominance of the domestic system post-crisis as validations of their pricing. The new wave of cost-cutting, evident in the ANZ interim result and likely to be evident in those of its peers, could underwrite solid growth in the banks’ near term earnings to offset the modest levels of credit growth in the system.
The banks’ share prices started taking off about a year ago, about 12 months after the share prices of the major resource groups started to tumble from their peaks and just ahead of a broader surge in sharemarkets generally, although it took a few months before the ASX joined in.
Given the dominance of the banks, the two big miners and Telstra of the ASX – their combined market capitalisations account for nearly half the entire market’s value – there is almost certainly a correlation between the decline in the miners’ share prices and the market rise, and the rise of the banks' values.
Investors wanting a liquid exposure to the Australian sharemarket really only have the banks and Telstra to play with.
It would also appear that the success, to a point, of the Fed’s strategy of keeping its rates at negligible levels to encourage investors into seeking higher returns than US Treasuries by taking more risk has been a factor in the strengthing of the bank share prices, among other asset classes globally.
Conventional investors have been chasing yield and hedge funds have been exploiting the opportunity to conduct carry trades by borrowing in US dollars or yen to invest in higher-yielding assets.
As it happens, Australian government securities and the Australian banks have very attractive risk versus reward characteristics, which is why the dollar remains as strong as it has been despite the big falls in commodity prices.
For domestic investors, of course, the Reserve Bank’s cuts to official rates have flowed through to bonds and term deposits. The franked dividends paid by the banks have, despite the equity market risk, become very seductive for yield-sensitive investors.
It is also, of course, the case that with compulsory superannuation there is a flow of funds covered by Australian equities mandates that has to be deployed somewhere. The liquidity in the banks’ shares, their solid and fully-franked yields, their solid earnings performances and the absence of many alternatives with similar characteristics makes them the most obvious destination for a disproportionate share of those flows.
So, there are a number of reasons that relate to global and domestic flows of capital and relative yields rather than more fundamental analysis that could help explain the market's rise and rise of the banks’ share prices to the levels that have Mott questioning whether those prices represent a bubble.
The Fed’s statement yesterday, revealed that at the committee’s April meeting its members again discussed how long they should maintain the current quantitative easing program under which the Fed buys $US85 billion of bonds and mortgages a month. The statement said the Fed was prepared to either increase or decrease the pace of those purchases to maintain the appropriate monetary policy accommodation as the outlook for the labour market and inflation changed.
For months the minutes of the Fed’s meetings have shown rising concern among the members of the committee about the potential of such a protracted period of loose monetary policy to encourage excessive risk-taking and financial imbalances that might eventually undermine financial stability.
Japan’s emulation of the US has probably added another dimension to those concerns and would be contributing to the flows of capital into this market.
The Fed has indicated in the past that it might start winding bank its QE program somewhat earlier than it had originally flagged, perhaps towards the end of this year.
That is going to be a delicate task, even if it is probable that the Fed will only stop buying bonds rather than starting a program of selling the several trillion of dollars of securities it will have on its balance sheet by then.
The moment the markets begin anticipating the shift in the Fed’s policy and the rise in US interest rates would signal there will probably be significant pressure on credit markets and large-scale unwinding of other positions.
The recent meltdown in the gold price has been linked to the Fed’s lack of concerns about inflation and apparent confidence it can end its quantitative easing program without causing massive disruptions to markets.
If there were to be a major shift in investors’ behaviour as US monetary policy began to normalise, one would expect that, to the extent that the Australian banks’ share prices had been inflated by yield relativities and weight-of-money, they would deflate to some extent regardless of whether they are in bubble territory or just fully valued by historical standards.
It is also worth noting that, whichever party wins the federal election in September is likely to confront a very difficult fiscal challenge, which it will want to attack as early in its term (and as far away from the next election) as possible.
With China’s economic growth rate softening; the eurozone still a shambles; the US economy still in low and fragile growth mode; Australian manufacturing and resource companies under pressure and the states dealing with tight fiscal positions of their own, a really contractionary approach at the federal level would inevitably have some negative implications for the economy and inevitably the banks.