Australian financials versus A-REITS
Posted on 17 June 2010
What to make of the following charts that map out the relative performance of the ASX200 financials (XXJ) and ASX200 A-REITS (XPJ) across the last decade (as described by their respective 50 day and 200 day moving averages)?
Interesting. The two indices paced each other to the market top in 2007. From there, the financials fared better through the worst of the turmoil, and have outperformed on the rebound. Notably both had their 50 day moving averages drop back through the 200 day MA recently – which often foreshadows further price weakness.
Now apart from the usual caveats that must be observed when looking at indexes – particularly the performance distortion that comes with index stock selection – what to make of this relative outperformance by financials and what does it portend?
Outlook for financials
Australian financials have enjoyed the liquidity lead uplift in risk spreads as much as any of their global peers. But looking ahead, the key drivers of earnings growth in recent years – fee income and growing lending books – appear to be coming up against strong headwinds.
Whether Australia’s housing market bursts or simply leaks for the next decade, it’s pretty clear that the top is now in (for an argument as to why see here). Even if governments were to find further ways of propping up demand – the fact that current prices are at least partly the result of the last cash injection means that the limit to this subsidised demand is close. The odds are short – household driven credit expansion has peaked (see here for latest Australian credit data).
While lending growth can be expected to stall, bank funding costs are on the rise. Risk premiums are heading north led by the step-up in sovereign debt that is taking place globally. While our banks may be well capitalised, and the risk of default is small (see speech on bank stress testing by APRA’s John Laker here), our hitherto reliance on foreign debt means that we are directly impacted by rising global credit margins (see here and chart of bank funding costs here). It’s little wonder that the battle for deposits has been heating up – but even this has its limits as ultimately higher risk premiums will flow through to the domestic markets. In summary, expect banks funding costs to rise.
Up until now though, banks have been able to pass on higher funding costs to their borrowers. In fact as the RBA noted, net interest margins actually increased through the crisis (see chart here). Once again though, this good news is history. With mortgage rates already starting to bite into the performance of their loan books, there is a tradeoff between increasing margins on the one hand and worsening loan arrears on the other. My working assumption is that net interest margins are unlikely to widen from here.
Then we have the impending capital and liquidity requirements that are likely to flow from the crisis that will be another drag on our banks return on equity. From APRA’s Wayne Byre’s (here)
Nonetheless the clear message is that, as far as minimum capital requirements for banks are concerned, the only way is up (even from Australia’s more conservative starting position). Capital requirements – and in particular, equity requirements – for banks will be higher in future. That will be achieved via a range of measures, including higher minimum requirements, tighter eligibility definitions, capital conservation measures and counter-cyclical capital adjustments. And, since the G20 Leaders asked for it, we‟ll also have a (non-risk based) leverage ratio as part of the supervisory armoury.
Finally, our banks have had a well publicised growth in fee income in recent years. When times were good, people didn’t seem to mind. Now times aren’t so good, there is growing unrest. Witness the class action, being touted by FinancialRedress and funded by IMF Australia to recover ‘penalty fees’ (see here). While these types of activities are designed with the promoter’s self-interest firmly at the fore, it is indicative of a changing mood. The net result – bank fees are unlikely to achieve another 9% growth this calendar year (chart from the RBA’s annual survey on bank fees here).
Outlook for A-REITS
This post has already run on too long – so for the moment a couple dot points to consider:
- The A-REITS have reduced gearing – over the last 18 months, the listed property sector have been serial issuers of new equity at historically discounted prices. With gearing now down to the mid-30′s on average, the sector is well placed to weather any downturn in the domestic economy. As a generalisation, the risk of default is remote for participants in the sector.
- Risk spreads to continue to widen – while Australian non-residential property has undergone some repricing, the pricing of risk as embodied in capitalisation rates still lags the credit and equities markets. As risk spreads continue to widen globally, we can expect cap rates to follow – though with leverage reduced, the impact on equity prices will be similarly softened.
- Question is – what environment are current A-REIT prices factoring in?
Conclusion
1) Earnings of financials are likely to struggle against a confluence of negative factors
2) On the face of it, A-REITS look to be well positioned for a downturn in the domestic economy. On the flip-side though, can’t think of any macro variable that might be a catalyst for a re-rating of the sector. Regardless. more work required to get a view on what sort of economic scenario is reflected in current prices.
3) Intuitively, A-REITS to outperform Financials – on the basis that financials have material earnings risk, while A-REITS have a good deal of bad news priced in.
2 responses to Australian financials versus A-REITS
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Rohan,
Great post.
My comments for what its worth. Organic revenue growth is already missing as evidenced in the recent half year reports. The earnings boost from lower provisions can only go so far – so I agree completely that Financials are going to struggle from here.
On the A-REITs – do they deserve to trade at NTA? I think not because its hard to imagine them releveraging again anytime soon. Except for the highest quality trusts, I think many are going to struggle in growing NOI which means cap rates aren’t coming down quickly, and this is without taking into account the external pressures you mention above
Cheers
Thanks BK,
Still puzzling about A-REITS… Do they deserve to trade at NTA? Fair question. Agree that without the releveraging afterburners, property is going to plod along. And given that there’s further pressure to come on cap rates, maybe trading sub-NTA is where fair value sits in the current market. In the bad old days of the early 90′s, property trusts were trading up to 30% below after all. As I say, think I need to do some more work – but any help would be appreciated.
Cheers
Rohan