Now, one of the truest truism’s in financial markets is the saying that not everyone can be right at the same time. The reason is that if everyone has the same opinion, and has entered into the same trade in anticipation of that opinion playing out, then no-one is left to ‘buy’ or ‘sell’ to deliver the outcome that is the expected by the consensus opinion. This is what is meant by the phrase ‘the market has priced it in’.

But just occasionally, this rule is broken – most usually because people have not acted on the strength of their convictions.

The question then is whether the universal pessimism is baked into market prices – and if so, does this prohibit consensus actually unfolding.

Let’s quickly summarise the state of play – it’s pretty easy to paint the bearish picture:

1) Global leading indicators suggest we are heading into a synchronised slowdown in economic growth with possibly a double-dip for emerging economies like Brazil and India, and reasonable odds that the US and Europe will follow. The jury remains out on China – with its property development sector likely to falter and local governments loans being hived off bank balance sheets the signs aren’t great, but it’s a command economy and can put the foot back on the accelerator in short order.

2) Australia is in a difficult position. On the one hand planned capital investment is historically huge and coal and iron ore exports remain very strong – but unless you work in the sector, or own the resource, the benefit of this plunder is questionable. The main way that the Australian economy benefits is through the tax take – and that money has already been spent. So the bulk of the Australian economy by headcount at least is struggling under the weight of excessive debt, high interest rates and rising consumer prices. This is why residential property is turning up its overhyped toes and why retail sales have dried up.

3) With equity markets having enjoyed the global re-rating of risk and now looking weak at the knees, no wonder fund managers are feeling a little queasy about the outlook.

So we get to the crux of the issue. Have portfolio managers acted on their sense of imminent doom? If we had access to some meaty data on portfolio flows, we could have a real stab at answering that (it’s something being worked on). So the simplest proxy to get a feel for the answer is by looking at relative sector performance:

What we are looking at here is the 50 day moving average for indices for Consumer Staples (XSJ), Materials (XMJ) and Financials (XXJ). If fund managers had been rotating out of risk and into defensive stocks then consumer staples would outperform – and perhaps at the margin this has been the case since the most recent wobbles began back in March. But it certainly doesn’t look like a fully fledged exit. (We’ll come back to the performance of the financials in another post.)

Another way to look at this possible sector rotation is in the following charts that look at relative performance in a longer term context:

Notably, the more defensive consumer staples sector has been outperforming both the small cap and discretionary sector since March. So this would seem to confirm the trend. But for mine if we were to really be seeing an exit from the risk trade it would show up in a flight from the resources sector – and to date, this is just not really happening.

Conclusion – while fund managers may be very pessimistic about the outlook, it does not look likely that these opinions have been ‘priced it in’. This’d be consistent with my colleague’s reply when asked, “Are portfolio managers underweight risk then?” …”I don’t think so.”

If there was any doubt about the importance of the umbilical cord between Australia and China, the following chart mapping the relative performance of some of the world’s stockmarkets bears this out:

Australia’s economy, that was being at risk of being left behind in the sandpit in 2000, has ridden the China bull all the way to the bank. We can see the importance of the resources sector in driving this performance in a comparison of the materials to the financial sector over the same period:

The sucking sound emanating from the financial sector is profoundly disturbing.  Remember that over the same period our pension savings pool rose from ~$500bn to ~$1,500bn, and our household debt climbed from $350bn to $1,250bn currently!

One more perspective on this – consider the following chart from the ASX (here) that gives a breakdown of market capitalisation by sector in 1989 and 1999:

In the midst of the Asian crisis, admittedly as a swathe of Australia’s mining sector was being repossessed and the average return on shareholders equity was just north of zero, the market capitalisation of the sector was ~$100bn in comparison to ~$200bn for the finance sector.  Fast forward to today, and the financial sector is around $425bn versus a resources sector closer to $400bn.

With the Australian economy at best stalling, hope our surrogate continues to take their vitamins.

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.

If this analogy holds – then the financial press is a ‘generic drug manufacturer’ – they are a volume producer, though our expectations are that the quality of analysis should at least meet minimum standards.  So when The Age publishes an article on rising bank funding costs “Big Four prize deposits as long-term funds costs rise” (here) – thought it might shed some light given our reflections last week (see here).  Unfortunately, the opposite is true.  It’s a confused but seemingly well informed piece of journalism – and reads suspiciously like it is intended to paint a picture of banks being squeezed by external market forces.

A summary of the points made in the Age’s article:

• The big four need to refinance $125bn in wholesale funding by September next year.

The RBA estimates that just under 20% of wholesale funding, or ~$90bn by our reckoning, is required to be refinanced over the next 12 months (see Financial Stability Review here).  This compares with long term debt issued by the banks over the last 12 months of $177bn, $92bn in 2008, and $58bn in 2007.  Not sure why The Age chose September next year as a relevant date.

• CBA has about $50bn to refinance over next 16 months.

I guess $50bn is a round number – so that might explain why you’d chose 16 months as a benchmark?  (Notably it is also around 50% of CBA’s total wholesale funding book!)  I can’t find any public statement by CBA to check this statement directly.  Piecing together two different charts (page 10 from this Treasury presentation and page 6 from a March Trading Update here) we could probably conclude that CBA has $22bn to refinance within 12 months and another $26bn between 1 and 2 years.  Maybe?

• Long term wholesale funding ~25% of bank’s funding needs.

From the RBA Bulletin in March 2010  (see here).

• Bank funding costs – the major theme of the article is that the ‘average cost of funding’ is rising due to rising “long term wholesale finance” costs.  These higher costs are driving up mortgage rates.  It also implies that deposits are a cheaper source of funding that can assist banks in bringing total funding costs down.

As a departure point, the following chart from the RBA (here) provides a breakdown of how the major banks funding costs have changed over recent years:

This is saying that average funding costs have risen from being flat to cash pre-crisis to around 130bps over cash currently.  The principle driver of higher costs are deposits (which also provide 48% of total funding by volume).  Long term funding has substantially assisted the uptrend.  Then the RBA has this to say about their outlook for bank funding costs:

“If bond spreads and hedging costs remain around their current levels, then as maturing bonds are rolled over, the average spread on banks’ outstanding long-term debt is estimated to increase by about 30 basis points over the next year and a half and broadly stabilise thereafter.”

The Age’s article makes the point that the ‘average cost of funding’ will rise by an additional 10 to 35 bps by the ‘middle of next year’ (using benchmarks to short-term money market rates that are difficult to reconcile with the RBA’s).  It doesn’t make it clear whether it is talking about the banks total funding requirements or just those costs relating to wholesale funding.  This is critical as, if we take the RBA’s lead and add 30 bps to the average wholesale funding costs of the banks then, as they represent 25% of total funding, this adds 7.5 bps to the bank’s average costs across the whole of its funding book.

The point here is that the article from The Age infers that the rising costs of funding in the wholesale markets will continue to pressure the cost of mortgages.  The RBA’s publication would seem to confirm that rising wholesale costs have impacted bank’s but will have a diminishing effect in providing further pressure in the future.  Additionally, it suggests that increases in deposit rates have had an even bigger impact.

Finally, this chart from the RBA demonstrates that notwithstanding the impact of rising funding costs, the major banks net interest margins have actually increased since pre-crisis times:

In the RBA’s words:

“For all banks, most of the increase in their lending rates over the cash rate since mid 2007 has been due to their higher funding costs. For the major banks, however, there has also been some widening in their lending margins. Information published by the major banks in their financial statements shows that the average NIM on their Australian operations was around 2.4 per cent in the second half of 2009, about 20–25 basis points above pre-crisis levels”

In summary, it’s notable that The Age highlights the amount the needs to be refinanced and the rising costs, against a backdrop of the “consequence” that the “cost of mortgages…is set to remain high” as “banks pass on higher funding costs”.  We could be forgiven for thinking that this article has blended the ingredients to a specific recipe.

(Note: one happy outcome of reviewing this article in detail has been that I discovered that I had omitted to include CBA’s wholesale funding that needs to be refinanced in the next 12 months in my analysis last week.  Not that it materially changes the conclusion – $50m would represent ~50% of total wholesale funding but ~10% of total funding.  The clear conclusion from the forgoing analysis is that it is deposits that are the biggest driver of funding costs – and even then net interest margin is determined by the ability of the banks to pass on higher mortgage costs, something that they have proven adept at in the recent past.)

Australian banks trade at a premium to their international peers

Our banks are trading expensive relative to their global peers (like this simple analysis from Citibank – via Alphaville here).  There are many valid arguments put forward to support this – such as “Australia has…”:

• A stable (and consolidating) banking oligopoly
• A mortgage market structure that has historically lead to low default rates
• Recent population growth at ~2.5% per annum
• An economy leveraged to the industrialisation of China and India

On the other hand, an oft cited risk to our privileged position is that as a capital importer we are reliant on the good graces of our creditors – something that becomes more fragile with national borders getting firmer by the day.  How are our banks exposed to the rising cost of risk?

A snapshot of the Australian majors balance sheets

It’s a big question, and not one that can be answered in a short(ish) note.  Just want to focus on the most obvious aspect of bank funding in this respect – the wholesale debt market.  Following is a quick summary of the four majors balance sheets:

In short, ANZ has 20% of its loan book funded in the wholesale markets (“Bonds”), CBA 22%, NAB 35% and WBC 33%.  That’s not insignificant in itself.  Whether ‘deposits’ are directly exposed to international capital flows is something for further investigation – at the very least, rising risk premiums will flow through to deposit rates eventually.  But let’s leave deposits for another day.

How much of this wholesale funding comes from international capital flows?

According to the RBA, Australian financial institutions have ~$320bn in offshore funding – something approaching 70% of their wholesale long term funding requirements.  We can get a glimpse of the make-up of this across the market via the government guaranteed funding scheme.  At it’s closure in March this year, there was approximately ~$140bn in long-term funding guaranteed.  A breakdown of this guaranteed debt by borrower is:

And then looking at the maturity profile of the guaranteed debt:

So what does this tell us about our bank’s international funding requirements?  Not a whole lot other than it looks like going into the end of calender year 2011, the banking sector will be hoping for a favourable pricing environment for the refinancing of a reasonable lump of debt (~$60bn) across 2012.

Wholesale funding requirements of a major trading bank

Absent the bandwidth to analyse each of the majors individually, here is a summary of CBA’s wholesale funding requirements:

CBA has a reasonable slab of debt that needs to be refinanced over the next two years – $26bn represents ~25% of its total wholesale funding requirement.  Note too that amount is five times the volume of guaranteed debt.  If we were to extrapolate that to the rest of the sector, the total wholesale funding requirement looks more like $300bn (of course, given the sample size it’s a highly dubious extrapolation – but point taken on it being significantly bigger than $60bn).

But does this mean the banking sector is unduly exposed to international capital markets?

Well using CBA as an example, the simple answer would be no.  At just over 5% of the aggregate of its loans outstanding – the wholesale refinancing requirement of CBA for the next 2 years is manageable.  The impact of higher funding costs would certainly impact margins – but it is not a game-changing event in isolation.  (Note what applies to CBA may not apply for others…in the interests of expediency I’m using CBA as a litmus test.)

But cost of funds will rise

The point is that rising risk premiums in the international capital markets will flow through domestically.  If international capital costs are higher, local deposit rates will ultimately follow.  Bank margins will be squeezed.

Conclusion

Does this all mean Australian banks are unduly exposed to international capital markets?  Based on the toe in the water, the answer is no (unless ‘deposits’ are hiding some international capital flows).  The wholesale funding requirement looks like it is manageable even under stressed conditions.

However, the global cost of risk is on the rise.  Not necessarily due to inflation pushing rates up (the deflation/inflation debate is one that is yet to be won) but simply because risk is being repriced.  No amount of money printing will solve this – it, in fact, reinforces the trend.  This is the reason why Australian banks have been forced to ratchet up loan rates ahead of official rate rises.  It is a trend that has yet to run its course.  And it alone is sufficient to step warily around bank earning forecasts for some time to come.

Epilogue – Expect the government guarantee scheme to be reintroduced

The scheme commenced on 28 November 2008 and closed to new liabilities on 31st March – existing commitments will remain guaranteed until they mature (subject to the requisite fee being paid).

Under the scheme, Australian ADI’s (and qualifying others) got deposits and funding guaranteed by the Commonwealth Government for up to 5 years. A fee of between 70, 100, or 150 bps per annum is payable on the guaranteed amounts subject to the rating of the entity receiving the guarantee (respectively AAA to AA-, A+ to A-, BBB+ or below and unrated).

This has been a good little earner for the government – it booked $103m in February ($111m in January) and $1.3bn to date under the scheme. The fee structure is sensitive to the exchange rate on foreign currency denominated borrowings – that is, the fee is paid on the face value of the foreign currency amount borrowed (AUD down, fees up).

Given the perceived cost of guaranteeing bank debt is low, while the revenue is large enough to be meaningful, I think we can expect the government will be credit wrapping bank debt again in the future – regardless of whether it distorts Australia’s capital markets.

Technicals – uptrend has been broken, while longer term downtrend from 2007 peak remains afoot.  MACD firmly trending lower as is momentum.

Fundamentals – banks have been making hay with widening margins and loan books.  For mine, they have just attained peak earnings for the forseeable future as the housing market has topped out and there is a material risk of increasing turbulence in these loan books as we head deeper into 2010.

Conclusion – Sell the rally

Leadership in the Australian market’s rally since March 2009 has come from financials and the materials sectors.  It was notable then that the recent high in the All Ordinaries was not matched by the financials.

XXJ was rejected off the longer term downtrend from the September 2007 peak while it has definitively broken the Mar-09 uptrend.  With the weekly MACD crossing over, expect further weakness in the sector.

Turning to the materials sector.  While that line from March remains unbroken, the trend is up. Yet there are signs of weakness that will be a worry to those with their Tonka trunks full of dirt.

Is that weekly MACD turning over?  Considering the weakness in the AUD and CAD – seems like something is afoot.  Both have broken their uptrends and have formed double tops…

And then there is the Baltic Dry Index – that peaked in November and has been dithering through January looking for direction – while the CRB has similarly pulled back from its January highs.

On balance, the current selloff has more legs.  Having pulled back in a hurry, we may pause for a smoko, but for mine the risks are to the downside with a test of the 200 day MA (XJO ~4350) the most likely scenario.

The Australian equities market is at a crossroads – trading in a ever narrower range and refusing to capitulate (as I’d been expecting right about now). Unfortunately, arguments can be made for both another fling higher and a more substantial correction.

The bulls can simply point to the fact that we remain in an uptrend.  The recent consolidation suggests a break of ~4800 would target a swift move to 5100-5200.  Certainly the slow stochastics have retraced to a point that would support the case that this was wave 4 and the final push higher is in the wings.

For a deeper test, need to break the most recent low around 4600, which would take us through the March uptrend and give rise to a great deal of hand wringing and flatulence.  Supporting this view is the crossover of the weekly MACD and the fact that momentum continues to trend lower and has broken to new lows for the move since March.

Interesting that this same pattern is being mapped out in the AUDUSD – except that here the Aussie has broken its March uptrend line.

The carry trade is wavering.  Further strength in the USD could lead to unwinding of risk positions across the spectrum.  For the moment, commodities are hanging tough – consider the chart of the ASX200 materials sector (XMJ):

If we are to have a move lower, this sector needs to join in cause, as with weakness in the financial’s continuing, it has been the metals sector holding our market up.  In fact, could be argued that it will be financials that underwrite a surge higher, as they may be due for a bounce as they approach various moving averages and that damned nicketty March uptrend:

Staples, consumer discretionary and property are also all looking weak – so on balance still favour the downside from here which is why I remain small short.  Just that with Christmas upon us, we have turkeys to stuff and ducks to confit – lack of interest might just dictate that this market goes absolutely nowhere.

It’s not been a great sign of strength for the global equity markets that indexes like the All Ordinaries, Canada’s TSE and the Russell have not joined the S&P at new highs.  Well let’s see what is happening in the bowels of the Australian market to see how this has come about.

First up, the strongest index in the Australian market – XMJ – the materials where the miners reside:

Nothing but uptrend here.  It has just pushed through a 50% retracement of its entire downdraft.  No signs of weakness here.  If the All Ords was just miners we would indeed be at new highs for the year.

So what the hell is happening with energy (XEJ) then?

It topped nigh on 6 weeks ago.  The MACD has crossed over, volume is spiking higher on down days/weeks.  This index is not the picture of health.  But maybe that is sector specific – plenty of analysts have been downgrading their oil price forecasts recently as they ratchet back demand assumptions while increasing inventories.

On the other hand, the small caps are not looking to flash either (XSO):

At least it has tried to retake its highs.  But a failure at the recent highs with the MACD also spilling over has this index on the tightrope without one of those long poles (any tightrope walkers out there know the technical name for it?).  It is one index that needs to break higher soon – it surely won’t recover so quickly from a second breakdown through its uptrend.

Of most concern are the financials (XXJ):

This index also peaked 6 weeks ago.  Given it is a heavyweight in the XJO – it is the primary reason for our market failing to push to new highs.  Note the MACD has crossed over, momentum has broken to new lows, and volume has been heavy into the weakness.

Conclusion:

If broader market weakness sets in, it’ll be lead by a breakdown in the financials, but will need materials and energy to follow suit.  In the absence of a catalyst, hard to imagine that the market will simply collapse under its own weight.  But I guess stranger things have happened.