The resurgence of the virus in NSW and VIC bringing tighter restrictions and border closures, including an extended ‘State of Disaster’ in Victoria with lockdowns reimposed, brings an extended drag on the Australian economy and with that, the nascent recovery momentum is deteriorating. The recovery has begun, but conditions remain tough, particularly as community transmission remains prevalent in Victoria. The nascent economic recovery is hampered by the realisation that living with the virus is the new normal, which works to depress confidence and heightens the fragility of the recovery. Thus, weighing on both the speed and shape of the rebound, consistent with stalling consumer confidence that has prevailed as Victoria has moved into lockdown again and NSW works to suppress smaller outbreaks.
However, beyond the impact of COVID-19 and the presiding economic shock, the banking sector is low growth globally, and Australian banks are no exception becoming increasingly “ex-growth”. The sector faces increasing costs via technology and compliance expenditure, increasing competition and persistent margin pressures from the extended low interest rate environment, squeezing the outlook for profits and future dividend/capital growth.
Focussing on recent updates from Australia’s “big 4”
There remains a substantial degree of uncertainty with respect to economy, the virus and the consumer. Embedded in this uncertainty is a range of outcomes. This is far from avoidable for the banking sector, whose business sits at the heart of the economy and cannot escape the crisis unscathed.
As a direct result of the presiding economic crisis a significant proportion of loans across the banking sector remain on deferral. A large proportion of mortgages on deferral sit within NSW and VIC where the housing and rental markets have suffered the most. And for small businesses, the deferral packages sat at 6 months from the offset, so the updates on deferral balances and numbers will not be clear until full year updates. Not a great recipe for heightened default risk over the coming months.
Provisioning for bad debts remains quite low and it is hard to get a true read on the true state of the loan books given the economy remains on life support and many loans remain in deferral.
The fresh lockdowns in Victoria, with the stage 3 restriction reimposed in Melbourne on July 8 and move to Stage 4 restrictions on August 5th, also not reflected in the recent updates. The level of government support also remains high and the additional sugar hit to household balance sheets from the superannuation early access scheme is a real wildcard, meaning it is very difficult to extrapolate the trends and default levels seen to date into the future.
For Australian banks at the point that the stimulus measures are wound back in October and subsequently withdrawn further down the track, rising consumer credit defaults, bad debts across residential mortgage books and higher impairment charges will increase substantially, denting returns into 2021 and 2022.
The reality is no one of knows what the underlying state of the consumer looks like, minus the additional and temporary government aid. Meaning there is a far from insignificant probability that the trends seen to date may be providing unreliable signals for the future, something which is not reflected across securities/assets linked to these underlying outcomes. This coincides with the virus continuing to wreak havoc in Victoria, an extended ‘State of Disaster’ with strict lockdowns reimposed brings a prolonged drag on the Australian economy and with that, the nascent recovery momentum is deteriorating.
Under present conditions’ consumer demand will face a difficult recovery, especially as government stimulus measures begin to scale back in October and the one off boost of the early access to superannuation, a real wild card in gauging discretionary consumption patterns, fades. According to the ABS, "The average weekly ordinary time earnings for full-time adults in Australia in May 2020 was $1,714 (seasonally adjusted), up 3.3% from November 2019".
Clearly as the government income support is tapered, household incomes will correct lower, presenting problems for mortgage deferral customers already struggling. Moreover, the recent disclosures from the banks reveal a staggering amount of mortgages, have been and remain, deferred. A large proportion of these loans on deferral sit within NSW and VIC where the housing and rental markets have suffered the most. Not a great recipe for heightened default risk over the coming months.
Come October JobKeeper payments will be reduced from $1500 to $1200 ($750 part-time) a fortnight and JobSeeker will be reduced from $1100 to $815 a fortnight. Demand faces difficulty most notably for face to face services where people are fearful of infection, but also across the broader economy whilst confidence is dampened by rolling restrictions and lockdowns, prolonged distancing measures and job insecurities/reduced hours worked.
This dynamic on the demand side is going to continue to create a lot of problems for businesses, hiring/ongoing layoffs, and bankruptcies or continued restructuring plans into the second half of the year. And for the banking sector, resultant deteriorating credit quality will impact capital, credit growth and profit margins.
At the root of the dividend decision lies this uncertainty and the degree of unpredictability that still remains with respect to economic and virus probabilities.
Dividends are being lowered or deferred so that companies can insulate their balance sheets and more readily absorb losses. And for the banks in particular in order to preserve capital to support lending to households, small businesses and corporates. The health crisis brings an unprecedented period of economic stress as measures to contain the spread of the global pandemic have ground economies to a halt.
There is no clear-cut answer, but (in 2020!) we are constantly reminded the future, and any forecast, is fickle. In the face of such uncertainty, deferring dividend payments and erring on the side of caution seems like the most prudent path. The decision to pay a dividend could go awry in the event of worst-case scenarios for the trajectory of the virus unfolding and in the current environment the decision to preserve capital should not be misconstrued. Particularly as insulating against the unexpected and increasing the capacity to support lending to households, small businesses and corporates in turn helps the economy along its return to normalcy, benefitting those same investors who clamour for dividends. Investing in bank shares does not provide investors with the divine right to receive a dividend, banks are pro-cyclical businesses, highly leveraged to the economy, something which many investors seem to forget.
Nowhere else in the world is the dividend decision so heavily contested. In fact, in Europe, the regulators themselves have taken the decision out of managements hands entirely, the ECB stipulating banks are not to pay dividends until at least October 2020.
Clearly the discrepancies arise from the Australian population being heavily weighted towards equity ownership relative to elsewhere in the world. But also, the bias within the taxation of retirement savings, or superannuation, skewed toward franked dividends. The traditionally juicy dividend payments from the “big 4” have attracted a large retail investor base and a large proportion of retirees (on a zero-tax rate benefitting from dividend imputation) who rely upon these chunky dividends for income. Hence the hotly contested dividend debate. Again, the answers are not clear cut, but perhaps a reminder of the cyclicality embedded in the economy and the banking sector. Something many Australians may have forgotten with the last recession dating back to 1991.
We suspect the crisis could be the harbinger of structurally lower dividend payments to shareholders for some time as payout ratios shift lower in tandem with the economy. Returning the pre-covid LEVEL of activity is a long way off.
An undue focus on dividends alone can cause investors to misconstrue risks and lose sight of the benefits of diversification and capital growth. With stock prices having fallen it’s important not to chase seemingly high dividends or yield traps at the expense of capital losses, future investment into long term growth and low-growth sector exposure. A deteriorating capital base will often be more painful for long term portfolio returns than accepting lesser dividend yields.