Key themes in 2019
In this report, we outline the key themes which we believe will impact the Australian equity market in 2019.
It will hardly come as a surprise to anyone the biggest issues likely to drive the ASX will be:
(1) the Australian Federal election, given the divergence in key economic policies (for instance with respect to negative gearing and franking credits);
(2) Housing and credit growth will again likely be a key feature as the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, hands down its recommendations; and
(3) the performance of the Australian banks, given their large weighting in the market and investors portfolios.
Australian Federal election
The Australian Federal election, expected to be held in the second half of May 2019, will likely have an impact on financial markets given stark differences in key policies between the two major parties. The two most obvious differences are Labor’s proposals to make changes to negative gearing and franking credits. In our view, given the perceived “radical” nature of some of Labor’s economic policies, it will use the upcoming election as a means to get a clear mandate to push through its policies.
Before investors argue over the merit of these changes and its impact, it is worth highlighting that even if Labor wins the next election it may take some time before any of these potential changes come into law. Also, equally important, what shape the final policy will take is uncertain as the Labor party may be willing to give some concessions. The only thing certain at this moment is elevated uncertainty around the companies and sectors most impacted by these policy changes.
Labor’s franking credit proposal
It is estimated the current dividend imputation regime costs the Australian federal government around $56.0bn over the next 10 years. Savings on this front will have a material impact on the budget. Labor is proposing to reverse the changes made to the dividend imputation system in 2001, where excess imputation credits are paid out as a cash refund. This effectively means the system will revert back to the original system, where imputations credits could be used to reduce one’s tax bill if they paid tax. However, if they didn’t or it did not match the imputations credit, then these imputation credits would be redundant (i.e. no cash refund).
Clearly, the policy change will impact self-managed super funds (SMSFs) who own Australian shares. The impact is likely to come in two forms – reduced income from their high franking investments (e.g. Australian banks) and potentially a de-rating in the holding value of these investments as they become less attractive (i.e. the market re-prices them lower). As the preamble highlighted, our view is that a lot needs to happen before this policy comes into law. We note Labor has already put in provisions for pensioners (those receiving full or part pension) who will continue to receive excess franking credits as a cash fund. Therefore, it is plausible that Labor may be willing to give further ground.
Leveraging the “franking credit” trade
Since the Labor policy was announced the markets have been debating the franking credit trade. Which is essentially ASX listed companies looking to return franking credits on their balance sheets ahead of Labor policy change via share buybacks. At the end of the day, prices may move around if/when this policy is implemented, but, in our view, fundamentals will always invariably drive the share price.
Labor’s negative gearing
The other contentious Labor policy is a proposal to cut the capital gains tax (CGT) discount to 25% (from 50%) and limit negative gearing to new homes. In our view, the core argument from Labor for the change is to drive new investment in housing, rather than encouraging investment loans to purchase existing housing stock. Labor argues the policy will work towards improving housing affordability. The policy will grandfather all existing investments under the current negative gearing policy. Will the change in negative gearing impact house prices? The answer is that it is difficult to say with 100% certainty how this may impact house prices. However, we address some of the key concerns raised relating to the rental market, in particular, below:
- It will drive up rent. Concerns that the removal of negative gearing will diminish investor demand for housing, which will in turn drive up rents. In our view any “sell off” in housing stock by investors who no longer view the return attractive enough will put downward pressure on prices which will only make it more affordable for owner-occupiers. This could potentially mean more rental supply vs. demand and therefore should keep rents at bay (or may even fall).
- New construction. Since negative gearing will be allowed on new construction, this should ensure new supply coming on the market. This could further assist in keeping rents from spiking given improved housing affordability (point above) and supply of new construction.
- Investor returns. In our view housing investors’ expectations of returns from their investment property will likely adjust to a new equilibrium if changes are implemented, rather than no appetite for investment housing at all.
House prices in Australia experienced a correction in 2018. A decline in loan approvals has clearly played its part, with investor loans in particular coming off as macro-prudential rules took hold during the year.
APRA (Australian Prudential Regulation Authority) has announced a number of macro-prudential measures since 2014:
- December 2014. APRA announced measures to reinforce sound lending practices by financial institutions in Australia, with investment lending the main focus. Specifically:
(a) Supervisory actions may be warranted where APRA sees large volumes to high-risk lending – high loan-to-income ratios, high loan-to-valuation ratios, interest-only loans to owner-occupiers and long tenure loans.
(b) Applying 10% growth threshold on property investor loans.
(c) Loans to new borrowers should include minimum serviceability tests – including an interest rate buffer of 2% above loan rate, with minimum assessment rate of 7%.
- March 2017. Further measures announced, specifically:
(a) limit new interest-only loans to 30% of total new residential mortgage lending (including strict limits of interest only lending at loan-to-value rations (LVRs) above 80%).
(b) Manage lending to investors to remain comfortably below 10% growth limit.
(c) Ensure serviceability metrics are set at appropriate levels.
(d) Restrain lending growth to higher risk segments.
- April 2018. APRA removed the 10% growth limit on property investors and instead expects banks to impose internal limits on high debt-to-income levels and debt-to-income levels for individual borrowers.
Recently APRA removed the cap provision on interest-only loans and the 10% investor loan growth cap for most banks. Whilst this is a positive for the banks and credit conditions generally, we do not believe this will lead to a sharp reversal in lending growth. We believe the major banks will continue to exercise prudence with oversupplying to the interest-only loans segment. We therefore expect house prices to remain under pressure in 2019.
If investors want to take a view on the outlook for the ASX in 2019, a key part of this would include a view on the Australian banks. In May 2018, following the conclusion of banks publishing their full year results, we downgraded our banking positions. In our view, whilst valuations have come back, the current trading environment still appears un-accommodative to a material re-rating in Australian banks.
- Margin pressure. We continue to see pressure on this front for the major banks as we move through 2019. Banks’ net interest margins (NIMs) are likely to come under pressure as subdued loan growth ensures price competition remains elevated and upward pressure on funding costs as global rates rise. The growth towards owner occupier (from investor) and principal & interest (P&I) loans (from interest only loans) will put pressure on margins. We therefore, expect the general downward trend for NIMs over the past couple of years to continue over the short-term.
- Cost pressure. All four major banks are targeting a cost-to-income ratio of less than 40%, with NAB being the most aggressive (targeting a ratio of 35%) and ANZ looking to take out 10% from its costs base. We have already seen increased compliance costs and with revenue/margin pressures, we are unlikely to see the majors significantly move the needle on the cost-to-income ratio in the near-term. However, we expect efficiency gains in other areas to help mitigate the impact, leaving the cost base largely stagnant in the near-term. We believe over the long-term the banks could be a beneficiary of increasing application of technology in the day-to-day operations (e.g. automation and AI) which could help structurally lower banks operating cost base.
- Impairment charges. Asset quality for all four major banks has been a key positive driver of earnings, with impairment charges at historical low levels. In FY18, the average impairment charge for the major banks was 13 basis points (bps) this compares to the most recent peak of 77 bps experienced in FY09. With low interest rates, solid economic growth, banks’ low LVRs and healthy employment rate, we do not anticipate this metric to see a material spike. However we do expect some deterioration in impairment charges from their historical lows.
- Dividends. For the most part, the outlook for dividends across the four major banks remains largely flat. Further, dividend payout ratios are likely to remain elevated to maintain yields. In our view, absent any major earnings shock, dividends are likely to be maintained as the banks are likely to continue pushing the payout ratio if required. Franking credits make the dividend yields of all major banks significantly more attractive (and therefore provide share price & valuation support), the removal will impact the share prices. We do not believe it is “in the price” at current levels.
- Valuation. In our view, banks valuations are starting to look more appealing. However, the current valuations do not account for an earnings downgrade from current levels (i.e. expect a benign trading period for banks) in our view. Therefore, a shock on the policy front (such as Labor’s franking credits) or deterioration in the economic outlook will still hit valuations and share prices in our view.
Key picks 2018 report card
2018 – it was rough…
On a relative basis, the Australian market outperformed its global peers in key developed markets and most emerging markets. As the table below highlights, the ASX200 delivered a total return of -1.5% for calendar year 2018, despite facing its own challenges during the year, which includes ongoing political turmoil (new Prime Minister), royal commissions (banking RC and one announced for the Aged Care sector) and negative housing data (e.g. declining house prices and home loans data).
Concerns over moderating global economic growth, the U.S. Fed potentially leading the U.S. economy into a recession by being overzealous with rate hikes, emerging market debt and Brexit all compounded to cause other indices to experience double digit declines.
At the start of 2018, we called out the following stocks as your key picks for 2018. This basket of stocks returned on average +3.3% versus ASX200 at -1.5%.
- Aveo Group
- Afterpay Touch
- Clydsedale Bank
- Mayne Pharma