When big business cracks

Summary: Share market signals aren't looking great, at a time when panic is sweeping through top management at our top banks, and the ALP is threatening to derail property investment.

Key take-out: The dethroning of our banks and the cracks in the US tech sector may not seem to be correlated on the surface, but there are interesting parallels that investors would benefit from noting.

The share market signals coming out of the US and Australia are not good. In the US, investment bank Morgan Stanley has declared a bear market as Wall Street falls to a 13-month low. In Australia, the standards of our top bank management are being brought into question, and we are in danger of lunging from a banking culture that overemphasised profits at the expense of customers to one where profit achievement is relegated to a backseat.

The Banking Royal Commission has delivered many surprises about the standard of management in both bank and insurance companies. With the CEOs now appearing before the Commission we are getting to the nub of the problem. 

The banks now admit, that in past years, they discarded the interests of their customers in an all-out drive to increase profitability and share prices. They now declare that was a bad thing. 

The profitability and dividends produced by the banks attracted Australian savings on a massive scale. The Big Four banks began to dominate our share market as a result, capturing the equity savings of a vast number of Australians.

During this period of not putting the customer first, it’s highly likely the banks increased their lending risk profiles. That risk-taking won’t become apparent for another year or so. The future damage will depend on the future level of house prices and employment. 

My great fear is that, just as the banks swung too far and virtually overstated their real profits, in the reaction they might go too far the other way and act against the interests of shareholders.

Panic sets in

The repercussions from the Banking Royal Commission, the much tougher stance from the regulators, plus, the possible court cases, will all push the banks towards making customers number one, two and three on their priority list. The truth is, any enterprise must look after both customers and shareholders, and in most cases the interests can be aligned. 

But inside the banks that are facing criminal prosecution there is a degree of panic sweeping over top management. That became clear this week when Commonwealth Bank CEO Matt Comyn started blaming his predecessors rather than coolly looking at the total situation.

If you’re taking a long-term view of share prices, this may not sound good. However, we shouldn’t forget that the banks are a magnificent franchise that’s able to reduce costs via technology. 

Some banks will manage this crisis better than others. Meanwhile, both the NAB and CBA have major investments in their wealth management operations, and it is likely these activities, along with the AMP, will lose considerable market share to the industry funds. 

The attitude of the industry funds towards profits and banks will play an important role in determining the outcome of this swing in emphasis from profits back to customers. 

Building on banks... to houses

During the weekend I was yarning to an astute building and land-developing family who see the current downturn as a long-term opportunity.

However, they made a point of emphasising, in its negative gearing plans, the ALP doesn’t understand that the attitude of those investing in property is totally different to those wanting to buy residential property to live in. 

Those buying for residence almost always take a longer-term view of a market because they plan to stay in their dwelling for a long time. Obviously, plans change, and there is also a group of residential dwellers who move houses regularly as part of the renovation process. 

But those who negatively gear investment property are dominated by a one- and two-year view of property prices. After all, if your interest and other outgoings exceed the property’s income, even though you might gain a tax deduction, you are still aiming to achieve a capital gain that more than offsets the income reduction. Accordingly, you watch very carefully the market value of your property, maybe even to quit if the charges get too high and the capital gain is not eventuating. 

Under the ALP policy, if an investor is erecting a property, then they can engage in negative gearing against their income. But when the investor wants to sell, then the buyer can’t claim the interest or the depreciation against other income. Immediately after the original purchase is made the house falls in value. 

This will simply take most investors out of the market and reduce investment in houses to levels where there is positive gearing. That means much lower dwelling prices in most areas. That process will be helped by the inevitable sharp rise in rent in areas where there are shortages. 

Given this is all taking place at a time of a credit squeeze imposed on the banks by the regulators, and a change in the attitude of bank management towards profits, we are looking at a very dangerous cocktail. 

And the problem is, there is a substantial backlog of dwellings that have been ordered and will be erected during 2019 and even early 2020.  Bank finance has already been arranged, for the most part.

All these pressures will not be apparent for some time. My fear is that, therefore, the warnings will be dismissed until suddenly the timebomb explodes. 

What’s the good news? While we can expect a sharp fall in residential building activity, our state governments, particularly NSW and Victoria, are spending vast amounts on infrastructure, creating many construction jobs which will lessen the blow of the likely decline in residential dwelling prices.

Cracks in the tech set

Onto the global stage. We are seeing a re-evaluation of the expensive US technology stocks as the market realises they may be badly affected by the US-China trade war. But I think it goes much deeper than that.

During the week, my old Apple computer crashed. It really was no surprise, but when I went to replace it with another Apple computer, there were a couple of issues. The salespeople were helpful, but not all the products were available, and the Genius Bar tech team at the store had none of the enthusiasm that was there six or seven years ago when I bought the original computer. 

While it might be illogical, I couldn’t help but link the differences in enthusiasm between the Apple operation of, say, seven years ago, and today with the recent falls in the Apple share price. It is really hard to maintain entrepreneurial momentum when an enterprise gets bigger and bigger. I think that is as important as a factor in the US tech sector decline as the trade war. 

And in a strange way, albeit on a smaller scale, we are looking at four banks that expanded rapidly and had great difficulty in managing their bigger organisations. Of course, US technology stocks are many, many times larger than our big banks – but the world we are running into provides incredible opportunities for smaller and medium enterprises. The trouble is, many of these businesses very often fail because in the early years they carry considerable risk. 

Nevertheless, the big winners in the future seem to be those that can pick the medium-sized stocks that will emerge as leaders. It is an area that requires great expertise.