In the lead up to the last federal election the issue of first homeowner’s inability to enter the property market was poignant with voters and Scott Morrison released details of a new First Home Loan Deposit Scheme. From 1 January 2020, eligible Australian first home buyers with a 5% deposit can get home loans without lender’s mortgage insurance (LMI) through a government scheme.
Previously a borrower would need to save a 20% deposit in order to avoid paying LMI, which is an insurance, paid for by the borrower, to protect the lender against loss if the borrower defaults. If the lender is forced to sell the property and the full amount of the loan is not recovered, the insurance guarantees the difference. The additional expense of LMI has been a barrier to entering the property market in the past as, for example, the estimated LMI on a $400,000 property with a 5% deposit is around $12,700.
Whilst the first homeowner must still repay the full loan amount, the scheme allows them to enter the market earlier as they can spend less time saving for the deposit. This can be combined with other existing state-specific schemes such as the First Homeowners Grant (FHOG) and relevant stamp duty concessions.
The scheme is further restricted to:
Owner-occupied loans on a principal and interest repayment schedule
The applicant(s) cannot earn more than $125,000 a year as a single or $200,000 as a couple
Access to the scheme is limited to the first 10,000 applicants per year on a ‘first in first served’ basis.
The maximum value of the purchased home under the scheme varies by state to state and between city and regional areas.
Whether the scheme will in fact increase first homeowners’ access to the market is being widely debated. Arguments are focussed on whether those people who could benefit from access to this scheme may struggle to be able to gain approval for a loan of that size based on current banking regulations. The effectiveness of capping the scheme to 10,000 applicants has also been drawn into question as this only represents around 10 percent of all Australians who bought their first home last year. Banks have also indicated that they are considering charging higher interest rates for the applicable loans. Their justification is that a borrower who has only been able to save 5% is at greater risk of default than one who has displayed a better saving history and saved more. Only time will tell.
Australian investors love two things: property and banks. And why not, the returns from both have been spectacular over the last 30 years. Which is no coincidence, given the more money people borrowed to buy property, the better the banks did. But just as there are now strong arguments to be careful about investing in property, so too, there are plenty of questions hanging over the banks as profits get squeezed between falling revenues and rising costs and valuations are challenging.
The mutually beneficial relationship between Australia’s four big banks and the residential housing sector really kicked into gear in 1988, when the first Basel banking accord halved the amount of capital banks had to keep on their balance sheets against residential mortgages. Getting the same return on half the capital meant profitability doubled overnight, and not long after, Australian banks boasted the best Returns on Equity (a measure of profitability) in the developed world.
This rescued the banks after they’d suffered one of their worst periods in history, lending too much money in the 1980s to wheeler-dealers like Alan Bond and Christopher Skase. Given the higher profitability, not surprisingly, the banks did everything they could to push more and more debt into Australian households over the ensuing 30 years, which in turn fuelled house prices and saw home lending go from about one-third of the banks’ loan books, to now closer to two-thirds. It was a cycle that self-perpetuated: as property buyers borrowed more money, house prices went up and the banks made more money, and the banks’ shareholders made more money.
Banks do best when demand for loans is high, but in August year on year credit growth dropped to 2.9%, the lowest since the data started being recorded in 1976. That’s despite interest rates having fallen to their lowest ever and both the regulator and the government doing their utmost to encourage people to borrow. With mortgage debt having doubled in the 10 years to early 2019, Australian households are up to their proverbial eyeballs in debt, in fact we have the second highest level of household debt to GDP in the world at 120%. For context, the average for developed countries is 72%, and in the US it peaked in 2007 just before the GFC at 99% (it’s now 76%), Ireland peaked at 117% (it’s now 44%) and Spain at 85% (it’s now 60%).
In short, there’s just not a whole lot of room for residential mortgage debt to grow anything like what it has over the past 30 years.
Low interest rates are also hurting the banks. Over the past 20 years Net Interest Margins (NIM), which are essentially the after-costs difference between what banks charge borrowers versus what they pay depositors, have dropped by more than a third from 3.3% to 2.1%. Deposit rates are already very low (a quarter of Commonwealth Bank’s deposits are receiving 0.25% or less!), but banks are reluctant to reduce them much further because they’re dependent on deposits for a big part of their capital backing. That means the banks find themselves squeezed between the rock of eating into their margins whenever they cut mortgage rates, and the hard place of enormous government pressure to pass on the full RBA rate cuts.
Scott Olsson, the banking analyst at fund manager Firetrail Investments, points out that other revenue lines for the banks are under pressure as well. “The banks customarily invest their non-interest-bearing liabilities, which is about 15% of their asset base, in three and five-year bonds, the yields for which have fallen about 70% in the past 18 months.”
He also points out that about 25% of bank revenues are from fees and charges, and they’ve been under enormous scrutiny from the likes of the Hayne Royal Commission into banking misconduct. “Over the past 18 months CBA has cut about $400 million from that revenue line, and while the others haven’t been as transparent, the boards are certainly reacting to the regulatory pressure. We know Ross McEwan, the new NAB boss, cut fee revenue hard when he arrived at the Bank of Scotland and he may do that again, which would just increase the pressure on all the banks.”
Bank profits have also been flattered over the past 5 years by bad and doubtful debt charges running at 0.10-0.15% of total loans, compared to an average of 0.25% over the whole of the business cycle. That means at some point they will have to run significantly higher to hit that average, and Olsson estimates if CBA’s charge doubles, profits would fall about 10%.
The costs side of the ledger isn’t doing the banks any favours either. They’re all talking about having to slash costs, but as the old investment adage goes, it’s an unusual company that can cut its way to prosperity. Add to that the demand for increased IT spend, remediation costs for their wealth management divisions of more than $8 billion (so far) and the potential for regulators to require increased capital, and those tighter revenue lines are getting spread thinner and thinner.
As much as the banks hate cutting their dividends, those added demands on revenue have left them with little choice, and there could be more to come. ANZ cut its dividend in 2016, and earlier this year NAB cut its interim dividend by 16% to its lowest level in nine years. At its August result CBA had to increase its dividend payout ratio to maintain its dividend, and Westpac just announced a 15% cut in its final dividend with its result, together with a discounted capital raising to meet the regulator’s requirement of an ‘unquestionably strong’ level of tier 1 capital.
Margin and revenue pressures have translated into declining Returns on Equity (ROE). According to APRA, the banking regulator, only 10 years ago ROE for the four major banks was 20%, but by the end of June this year it was 11%.
Despite that, Australian banks are among the most expensive in the world on two of the most common bank valuation measures: price to book value and the price to earnings (PE) ratio. The big four banks are currently trading at an average of 1.6 times book value, which puts them bang on double the UK banks at 0.8 times.
Australian banks are currently trading on a ‘forward PE ratio’, so how much you’re paying for the coming year’s earnings, of 13.7, a 16% discount to the overall market. The table below shows just how expensive that is compared to the rest of the world, where the global banks’ PE of 9.5 is 30% cheaper than Australia’s and sits at a 40% discount to the market.
And the chart below also shows that, while Australian banks’ PEs have traded at a premium to their global peers for most of the last 10 years, it’s reached a new plateau. It’s a level that seems too rich for overseas investors, as Copley Fund Research recently reported that 91% of the foreign investors they survey have zero weighting to Australian banks, the lowest on record.
Australian investors have long loved their banks, but as Damien Hennessy, principal of Heuristic Investment Systems, points out “While it’s understandable local investors are attracted to the relatively high dividends, they need to be aware that Australian banks are expensive in both absolute and relative terms.” That doesn’t have to mean not holding any banks at all, it simply means be mindful of how much you do hold.
Tim discusses why he’s still overweight growth assets and whether that’s because of growing earnings or just changing valuations, the low interest rate environment and the significance of negative bond yields.
This article appeared in the Australian Financial Review
Every interest rate cut is another turn of the screw for investors looking for a decent, low risk return. Many a risk averse investor is finding they’re no longer able to rely on cash or term deposits to generate a reasonable return, and are instead considering other fixed income alternatives, of which there is an almost bewildering range. As usual, however, for every extra percent of return you try to get, you have to accept higher risks, so to avoid nasty surprises, you need to understand what those risks are.
The explosion in the number of fixed income managed funds, ETFs and LICs over the past couple of years has come as product providers sniffed an opportunity to meet the demand for income in a low interest rate environment. According to BetaShares, in F2019 more money went into fixed income ETFs than any other category, in fact, 60% more than Australian equities.
Investors need to be aware the name ‘fixed income’ covers an enormous range of products, and they come with an equally enormous range of risk. The last thing a risk-averse investor should be doing is dumping a bunch of money into the highest yielding fixed income product they can find, without knowing what they’re getting in to.
Here are some basics to help you understand what you’re buying:
What is a bond?
A bond is a security that a government, or some other kind of entity like a company, issues that says ‘if you lend me $100 today, I’ll pay you an interest rate on that money (the yield), and every year I’ll pay you the coupon (the technical name for the amount of money paid, so if you have a $100 bond with a yield of 10%, the coupon will be $10) every year until the bond matures (it could be anything from 30 days to 100 years), and at the end of the bond’s life, I’ll give you your $100 back.’ It’s similar to a term deposit, except being a security, it can be bought and sold.
A bond’s maturity is usually fixed
Most bonds, especially government bonds, will have a set maturity date. There are some perpetual securities but they’re few and far between.
A bond’s yield will reflect the issuer’s credit worthiness
The less risk you’re taking to get your money back the less yield you’re going to receive. That can be reflected in an issuer’s credit rating from a company like Moody’s or Standard & Poor’s, but other factors also come into it. Interestingly, there are only 11 countries with a AAA credit rating from S&P, Australia being one of them, while the US’s rating is only AA+.
Bond yields can be fixed or floating
A bond’s yield can either be ‘fixed’, meaning it will pay the same coupon until it matures, or ‘floating’, meaning the coupon will be above some kind of benchmark (like the Bank Bill Swap Rate or LIBOR) and will be reset to reflect that rate from time to time.
Bond prices are not fixed
Bond prices can fluctuate, a lot. The average investor is almost certain not to buy an actual bond, but instead will invest in a fund or ETF, and it’s important to realise a fund’s unit price can jump around, depending on what kind of fixed income securities it invests in.
What makes a bond’s price change?
There can be a number of factors, but the main influence is expected inflation. If the market thinks inflation is falling, as it has recently, it will happily accept a lower yield to compensate for the reduced risk of the value of any future payments being eroded by inflation. If a bond’s coupon is fixed, meaning a 5% bond will pay no more or no less than $5 per year for every $100 bond, then it’s the price you pay for the bond that will increase instead. This is where you end up with the what seems weird at first: as a bond’s yield goes down, its price goes up, but in fact, it’s exactly the same as shares: if a share price goes up, its dividend yield goes down.
Duration risk: the bond price’s sensitivity to changes in yield
A bond’s ‘duration’ tells you how much the price should change when the yield changes. For example, according to JP Morgan, the Australian bond index has a duration of 5.4 years, which means if interest rates go up by 1%, the price should fall by 5.4% (and vice versa if rates go down).
That’s really important because the longer a bond’s life, in normal times the higher should the yield be, which appeals to income-oriented investors, who are normally more conservative. However, while a bond’s maturity and duration are not the same thing, the longer a bond’s life the more duration risk it has, and with interest rates already so low, there is heightened risk they could go back up, and even if that’s only by a little bit, those longer bonds could lose a fair bit of their value.
Credit duration: the bond price’s sensitivity to changes in ‘credit spreads’
Bonds issued by a company will typically pay a yield premium to reflect the increased risk that you might not get your money back. That premium is normally calculated as a certain percentage above some kind of benchmark, like the 90-day bank bill rate, and the gap between the two is called the credit spread.
‘Credit duration’ measures how much the price of the bond will change if the credit spread changes; a bond with credit duration of 3 years will fall 3% if the credit spread goes up (widens) by 1%, and vice versa.
Bonds have had an extraordinary start to the year, with the benchmark Bloomberg Composite Index rising 6.5% to the end of June. But almost all that return is because bond yields have fallen, with the 10-year Australian government bond yield dropping a full percent to 1.32% to the end of June, and it’s now even lower at 1.09%.
In fact, bonds have been a great investment since the GFC as yields have plumbed record lows. If you’re going to invest in fixed income securities now, you are, in part, placing a bet that yields will continue to fall, which may or may not happen. For investors looking to replace term deposits, you just need to keep in mind that fixed income does not necessarily mean low-risk.
Have you noticed how many articles have appeared recently scaring investors into thinking “markets have never been so uncertain” as they rattle off the well-worn reasons we should be worried: geopolitical tensions, elections, stretched valuations, extended cycles, the inverted yield curve. If you didn’t know any better, it’s enough to leave you thinking the best solution would be to find shelter and stock up on tinned food.
But many of these articles tend to be absurdly one-sided, you just have to look a bit deeper to find sound arguments to justify where share markets are trading.
1. The bond market is smarter than the share market and bonds say sell
The bears argue: While last year’s share market tumble bottomed around Christmas, bond yields around the world continued to fall, signalling the bond market expects economic growth to slow in the future. What’s worse, share markets have rallied at the same time as forecast company earnings have been going down. How can that make sense?
It’s not just economic growth perceptions that cause bond yields to fall, it’s also the perception of inflation and the fall in global yields is partly a reflection of the ongoing very low inflation we’re seeing around the world and the expectation that it’s likely to continue. For example, over the last 30 years Australia’s core inflation rate has averaged 3.8%, but the latest reading was less than half that at 1.3%.
If you look back over the last hundred years, when inflation is low share markets attract a higher valuation, as measured by a basic price to earnings (PE) multiple. At the end of March, the ASX200 was trading on a PE of 15.6 versus its average ‘low inflation PE’ of 16.5. On that basis, while you wouldn’t argue the share market is exactly cheap, nor is it overly expensive.
Another valuation measure to look at, especially for income-seeking investors in a low interest rate environment, is the share market’s dividend yield minus the 10-year Australian government bond yield. At 2.9% the dividend yield is at its equal highest margin above the government bond yield in the last 25 years – see chart 1.
Chart 1: the ASX200 dividend yield minus the Australian government
10-year bond yield is at an equal high for the last 25 years
More importantly, after accounting for inflation, at less than 0.5% the ‘real’ bond yield is getting perilously low, whereas the 3.4% real yield on shares is almost two and a half times its 25-year average of 1.4% and more than seven times higher than the real bond yield – see chart 2.
Chart 2: the real yield on shares is more than seven times higher than the real bond yield
Another measure is the Earnings Yield of the share market, which is technically the inverse of the PE ratio and essentially tells you the return on equity you should get from investing in shares, a focus for those aiming to generate a capital return on their investments. At 6.4%, it’s bang in line with the 25-year average, another indicator that the market is around fair value, but nevertheless attractive in the context of a low return environment.
Finally, the Equity Risk Premium (ERP) for the Australian market, which tells you how much extra return you should get from investing in shares rather than risk-free government bonds, sat at 4.9% at the end of March, comfortably above its 21-year average.
If you say a market’s expensive, you have to say relative to what. In the context of super low bond yields and an environment where the risk-free return barely leaves you with anything after inflation, equities start to look pretty attractive even if underlying company earnings are a bit weaker.
2. The inverted yield curve
The bears argue: Over the last 50 years every recession in the US has been preceded by an ‘inverted yield curve’, which is where the yield on longer-term bonds is lower than that on shorter-term bonds. Last month the 10-year bond yield snuck below the three-month yield, and we all know when the US sneezes the world catches a cold.
No less an economist than Nobel Laureate Myron Scholes wrote a piece arguing that forecasting a recession will automatically follow an inverted yield curve is no more than ‘data mining’ (an expression used to condemn either lazy analysis or the torturing of data to arrive at a pre-determined outcome). He points out that previous inversions came about because the Fed raised cash rates to an average of more than 2% above inflation in a deliberate effort to slow the economy, whereas in this cycle of nine rate rises it’s never been more than 0.3% above inflation.
In other words, the bond yields themselves don’t cause a recession, it’s what causes the yields to move that matters. In the past, recessions have coincided with the Fed actively trying to slow the economy, whereas this time around, they’ve said they’re trying not to.
3. The cycle is extended
The bears argue: Come June this economic cycle will be the longest on record.
So what, cycles don’t die of old age. Period.
Cycles normally die because of some kind of excess in the economy, and it’s hard to spot any of those right now, or because the central banks have to stomp on the brakes, again, no sign of that.
4. Geopolitical tensions
The bears argue: Pick your poison: Brexit, Trump’s trade war, any other capricious Trump crusade, Russian hacking.
Political shenanigans is a perpetual favourite of share market doomsayers, but the fact is, over the past 10 years the markets have sailed through whatever’s been thrown at them.
The UK share market has risen 11% since the Brexit vote, unemployment is at a more than 40-year low of 3.9% and GDP growth is the same as Switzerland and much better than both of Germany and France.
Trade wars are horrible, but the US’s S&P500 is up 11% since tariffs were proposed in April last year and in fact just hit a record high, the Chinese index is up about 1% over the same period, and the ASX200 has hit a 12-year high and is closing in on its all-time high too. By no means are trade issues inconsequential, but neither is it turning into a disaster as yet.
The bottom line
There are always reasons to worry about markets, but one of the most disingenuous expressions is “it’s never been more uncertain”, because in truth, markets are never, ever certain.
