Another earnings season, another bumper set of profits for Australia’s big four banks.
Macquarie analysts summed it up as follows:
‘The bank sector generally delivered solid results in 3Q17, underpinned by improving margins, low impairment expenses and further organic capital generation,’’
The ANZ [ASX:ANZ] net profit rose 5.3% to $1.79 billion in the third quarter. Commonwealth Bank [ASX:CBA] announced a full year profit of almost $10 billion, a 7.6% rise. The National Australia Bank [ASX:NAB] reported a 5% rise in third quarter profit to $1.7 billion.
Westpac [ASX:WBC] doesn’t reveal quarterly profit figures, but was expected by analysts to be broadly in line with its peers.
Taken at face value, things seem to be looking good for the banks.
For all its complexities, banking is actually a pretty easy business to understand. Banks take your money, and lend it back out at a margin. Luckily for them, they get to lend out each dollar deposited multiple times over.
This is the beauty of fractional reserve banking — beautiful for bank shareholders.
They then collect the interest, take away their expenses, write off any bad debts, and that leaves the profit margin.
Judging by the results over the past two decades, it’s a profitable business.
But these profits are mostly built on the house of sand that is the Australian property market. 60% of bank assets (i.e. loans) are in mortgages. And this doesn’t include small to medium enterprise loans, which also use property as the ultimate security behind them.
I know there have been plenty of property doomsayers in Australia for the past decade. And each time the Australian property market has proven them wrong. Listening to them would have been an expensive exercise.
But that doesn’t mean the arguments they make don’t stack up. Rather, it’s the timing that’s been off.
In my opinion, this tipping point is closer than ever.
And bank investors need to seriously weigh up some big risks right now. At the very least a long term decision to invest in Australia’s banks needs to be considered carefully.
Let me explain…
Waves of money
The housing boom in Australia has been driven along by rolling waves of money. These waves of money started over two decades ago — ironically, in the high interest environment of the early 1990s.
As double income families started to become the norm and interest rates fell from their highs, the property market was the primary beneficiary. People could afford more, and that is why loans are now over six times earnings rather than the three times earnings figure of earlier years.
The second wave of money was a knock-on effect of this first Aussie property boom. As properties rose in value a whole industry of accountants, property spruikers, developers and real estate agents sold the benefits of negative gearing as a path to wealth.
The baby boomer generation benefitted from this era of tax deductibility, low interest rates and surging property values.
This cycle reinforced itself over time and grew stronger and stronger. No one wanted to miss out.
Then the mining boom came along, and the states of Western Australia and Queensland saw average incomes surge well into the six figures.
We witnessed the birth of the ‘CUB’ (Cashed Up Bogans). They splashed out on shiny new utes, jet skis and lavish houses.
As well as the seemingly compulsory investment property.
In these good economic times, Australia attracted immigrants from around the world. The population growth added further waves of money to the growing property boom. Londoners sold their million-pound houses, and bought million-dollar beachside mansions in Perth.
When the GFC hit in 2007/08, property should have corrected.
But the Labour government pumped billions of our national savings into the economy. Interest rates had room to fall drastically, and the world embarked on a massive round of government spending to keep the world economy afloat.
Chinese government spending in particular helped get Australia through this period.
Australian property prices remained high. A weak global economy kept interest rates low. Property resumed its march upwards, with renewed confidence in its safe haven status.
Then the last two waves of money hit.
New rules allowed Self Managed Super Funds (SMSFs) to borrow to invest in residential property, a process which was previously banned. The financial planning industry were added to the wide network of professional property pushers.
People closed their diversified managed funds to put it all in a single house or apartment. And why not? Property hadn’t fallen for 20 years. People considered this a safer option than the volatile share market.
Then the last wave came. Chinese money has been propping up Sydney and Melbourne property for the past five years. To the Chinese, this is less of an investment and more of a hedge against their own government. It’s an easy way of getting money out of the country to the safety of Australia.
And all that leaves us where we are today.
Now let’s look at each of these factors to see what’s happening next…
The Australian property tides starting to change
The baby boomer generation is starting to retire.
With aged pension eligibility rules tightening, an increasing number of these people will need to look at selling a property or two to generate an income in retirement.
And as increasing numbers of people go into retirement homes, we could see a wave of selling.
With budget deficits increasing, there is increasing chatter about changing the negative gearing rules. I don’t think this will happen soon, but it could definitely be on the cards under a future Labour administration.
Rules were tightened in the last budget around putting money into super, so this could dampen the SMSF interest in property.
Economically speaking, a renewed mining boom would be good for the country but terrible for overextended mortgage holders in Sydney and Melbourne. If interest rates rise to their pre-GFC levels of around 8%, then a lot of new buyers will be in trouble. Inflation has stayed under control so far, but if it starts to rise for any reason, then interest rates will rise too.
Conversely, if we get an economic shock in the next few years the governments of the world have nothing left to counter it with. Interest rates are already at record lows. Budgets are already in deficit.
The savings buffer Australia had in the GFC is quite simply no longer there.
Double income families are very much the norm now, but even that’s not enough to buy a house in many Sydney and Melbourne suburbs. There’s likely no boost on the horizon from wages which are currently growing at a snail’s pace — not even enough to keep up with the cost of living.
Lastly there’s foreign investment. Just in the last week the Chinese government has announced they are going to reign in outflows of domestic capital into foreign property. Like Australia.
It seems to me that all the drivers of property price growth are set to go into reverse over the next decade.
The wash out
I’m not going to be foolish and try to pick a turning point. And I’m not going even say this process will definitely result in a property crash. It could just be a stall.
But it’s hard to see how the next 20 years will be anything like the last 20 years when the dynamics of what has driven it are changing so fast. Economies move in cycles. And we are clearly entering a new cycle.
Investors in Australia’s banks — who are likely homeowners as well — need to think carefully about how exposed they are to this sector. Bank profits are built on Australian property.
And I’ve not even talked about regulatory issues, the rise of fintech disruption and increasing bad debts in the mining states.
They are fringe issues compared to the property time-bomb. When you add it all up, the risks are heavy to the downside.
Editor, Money Morning
PS: Unlike me, my colleague Phil Anderson believes that the Australian property boom has much farther to run. Through studying centuries of stock and housing market trends, Phil has acquired remarkable insight into the cycles of rising and falling markets. He believes Aussie property prices are only halfway through their boom cycle. You can read more about his analysis here.