Welcome to the March edition of the Burrell Blog for 2019.
A Good Recovery, Some Issues to Work Through
The ASX 200 has continued its relief rally after the Hayne Royal Commission Report during February reaching 6263 on the 7th of March 2019. This is a 621 or 11% rally from the low of 5642 on Christmas Eve.
The view that the Hayne Royal Commission was a “sell the rumour, buy the fact” event meant that the better investment strategy was the opposite i.e. to commit funds to the market during January when the sentiment was negative, so as to benefit from the rally in the oversold banking system after the Hayne Royal Commission Report on 1st February.
In the February blog, your diarist considered that Westpac with its price fall from $30 to $25 had given up $15B in market capitalisation. Nothing that Hayne would write in his report would cause a loss of $15B in market value for Westpac. In considering what the banks were worth, the view was offered that a number of analysts had made no correction for remediation costs and CBA in its half yearly result only provided ~$200M. Evidence in the UK from these types of remediation issues is that they cost much greater amounts than initially anticipated and go on for much longer. Your diarist opined that it is prudent to reduce current bank fair value (FVE) by a dollar for remediation costs. Commentary from both sides of the parliament during the six weeks since the Hayne Royal Commission Report support this view. While the mechanism remains unclear, there have been some comments by government ministers that those with complaints against the banks over the past 10 years may be offered an avenue to bring those claims. This would unleash a holy unmanageable process.
The other issue with respect to bank valuations is the reaction of the banks to the criticism in the Hayne Royal Commission. The banks have been told that responsible lending processes may not allow the banks to use the House Expenditure Measure (HEM). HEM is a benchmark banks use to estimate a loan applicant’s expenses – a figure that becomes part of the determination of borrowing capacity. It was reported in 2017 that 70-80% of all home loans in Australia use the HEM benchmark. The HEM used for benchmarks are based on the state in which the borrower lives, the number of children and their lifestyle across four categories: student, basic, moderate and lavish. The vast majority of cases the basic lifestyle assumption was used which resulted in estimated expenses of $32,400. The view from the Royal Commission was that this measure may underestimate the living expenses for the borrowers.
The change of behaviour by the banks to validate expenses is difficult for individuals where poor records are kept of expenditure. It is a wholly different ball game where businesses and other entities requiring regular financial statements capture expenditures. Evidence to date is that the move by the banks to validate expenses, together with a reluctance to lend to children of family members, a preference for principal and interest repayments over interest only loans and a reluctance to lend to investors with more than 2 or 3 rental properties – is resulting in the loan approval process taking 45 days in a number of instances. On 8th March 2019, Bouris from Yellow Brick Road stated ‘I have never seen such difficult lending conditions.’ On 11th March one of the major merchant banks were quoted under the heading ‘Buckle Up, Credit Crunch is Here.’ The thesis of that article is that there is now a supply problem i.e. the banks are more reluctant to approve loans than they were in 2018 and it is taking longer to obtain those approvals. It may be that the proper target for bank share prices is $2 below the September 2018 levels, being a deduction of $1 for remediation costs and another dollar for the impact of the credit crunch.
Moreover there is little incentive on the government to solve any problem, when the labour party negative gearing proposal will take all the blame, even though the series of factors post Hayne is more complex. The more politicians bash the banks post Hayne, the greater the probability that the credit crunch will have a more damaging impact on the Australian housing market. The banks are also seeking to stress the mortgage broking industry, with the object of reducing the influence of mortgage brokers on the lending process.
Outside the banks, the February reporting season was mixed. A number of companies reported well, but there were several major companies that disappointed and the results season was by no means uniform. Careful analysis of the half yearly profit results has been a key focus for research and advising personnel at Burrell during February and March to date. Volatility does create opportunities and the February reporting season has done just that.
As this blog goes to press, there are four key geopolitical events impacting on markets. Brexit is but a few days away with no clarity on the most likely outcome. The European Union Central Bank (ECB) on 8th March revised GDP growth down in Europe ‘substantially’ to 1.1% for the current year, with the outlook to the downside. Inflation was also revised down to around 1.5%. The ECB announced there would be no change to fixed interest rates until inflation reaches 2%, a distant target in Europe. A monetary stimulus package was announced.
In effect the ECB was saying to the politicians that the Brexit uncertainty was not only a negative event for the UK, but had become a major negative event for the whole of Europe. The ECB has clearly chastised the politicians without saying so, for the uncertainty created and the negative impact on European GDP. Whatever be the outcome, a low growth Europe with several countries in recession seems the most likely outcome, a poor prognosis for the rest of the world.
Secondly, the China – US trade war keeps resulting in positive promises, but after the lack of outcome with the Korean summit, one could be excused for being sceptical. Nevertheless there is a significant driver for China to reach some degree of accommodation with the US, given the impact now being felt within China. The issues are complex and it is unclear whether a summit in April will eventuate.
Thirdly, the US has a series of geopolitical issues around the Muller investigation. The irresponsible budget tabled in recent days further adds to the lack of predictability and unease in the US political system.
Fourth, the long election time in Australia is clearly resulting in a lack of economic activity. T.R. Burrell always said elections were an excuse to do nothing and there is ample evidence of that occurring in the private sector. Fortunately, the backdrop of a balanced Australian Government budget, courtesy of tax collections in the mining industry, is facilitating spending commitments from both sides of politics, several prior to the NSW State Elections. Senior economist Bloxham from HSBC sees these spending commitments as a plus for Australian GDP.
However the five labour party tax promises are creating a degree of uncertainty, including whether a Senate controlled by independents will feel under obligation to pass tax measures which labour has taken to the electorate prior to the election. One commentator made the observation that there seems little recognition in the Australian stock market for the geopolitical risk arising from the changing in settings in May. Of course this is also complex – for example the Labour Party has the best policy concerning telcos with a likely write off of the excess cost accumulated for the NBN and resetting of the Telco framework between the NBN, resellers and consumers. Telcos may well be a beneficiary of a change in government in May.
Overall the lost value between September and December has been restored in the first 2 months of calendar 2019. The backdrop remains one of geopolitical uncertainty, but such uncertainty provides opportunities. A careful consideration of the half yearly financial reports of listed companies is a key focus in appraising whether current pricing of a security is fair, expensive or a buy.
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