After heading in one direction since the beginning of the year the bull market in bonds, which has driven growth and technology shares to lofty heights, is showing a few cracks. Growth is perhaps looking less bad and global yield curves have moved back from their doom heralding inversion. This raises the potential for some contrarian investing to deliver solid returns, but where do you invest without buying bombed out cyclicals with the risk of further downgrades?
On the domestic front we have seen a rebound in confidence post the coalition’s unexpected electoral victory with tax cuts, interest rate cuts and an easing in lending standards helping to stabilise the housing market. We have seen a rebound in auction clearance rates and house prices and recently we have received confirmation that lending growth is ticking up as well. This is all generally positive for the banking sector.
The largest negative overhang for the banks is the prospect of further interest rate cuts. Because much of their funding comes from accounts that they are already paying zero interest on, any further cuts by the RBA that they pass onto borrowers will pressure their net interest margins. A rebound in global yields and a stronger housing market are likely to mean that Philip Lowe and the RBA board will be more reticent to cut rates another 50 basis points as the market has priced in. A shift in expectations here could trigger a material short term rally in the banks.
The biggest risk in holding a bank is always a loan loss cycle. The easing in lending standards from APRA and cuts in interest rates by the RBA have shored up house prices and materially diluted this risk. There are still challenges facing the banks, the most significant of which is competition from non-bank lenders. In the tougher regulatory environment, the non-banks have been able to take share by maintaining more aggressive lending practices. There is the potential for the banks to drive profits by cutting operating costs, but ongoing increases in compliance, regulatory and remediation costs are likely to offset this for some time.
Of the larger banks our preference is for Westpac and NAB which are yielding around 6% before franking credits with the prospect for some modest growth in earnings and dividends. If you’re after something further up the risk spectrum then Bank of Queensland, yielding more than 7%, and with a greater proportion of zero-rate deposit funding, is more leveraged to a shift in rate expectations. Once the short term risks in the banks have subsided, their yields relative to cash are too great to ignore.
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