Market correction long overdue, but true test for banks yet to come

The market value of the big four banks has slumped almost $55bn, or 12.8 per cent since the market closed on Monday last week. Picture: NCA Newswire

As the major banks belly-flop deeper into correction territory, the hunt is on for insights from the past.

When will the pall of misery lift? And what will it take?

Unfortunately, the question of what happens next is not easily answered, mainly because the catalyst for similar corrections – fears of an imminent recession – never eventuated, apart from the Canberra-induced Covid recession of 2020.

That’s the problem with almost 30 years of uninterrupted growth.

Corrections, however, are another matter.

Since the market closed on Monday last week, the day before the Reserve Bank’s aggressive 50 basis point rate hike to 0.85 per cent, the market value of the big four banks has slumped almost $55bn, or 12.8 per cent, from $429.5bn to $374.7bn.

Share price losses on Tuesday ranged from 2.8 per cent for CBA to 4.6 per cent for ANZ Bank.

Barrenjoey bank analyst Jon Mott points to a series of events over the last 25 years which have each led to a significant 3-4 point downgrade in the price-earnings ratios (PE, or share price divided by earnings per share) of the big four banks.

They include the 1998 Asian economic crisis, the September 11, 2001, terrorist attacks on the US, the 2008 global financial crisis, the 2012 European debt crisis, the 2015 call by the David Murray-chaired financial system inquiry for “unquestionably strong” banks, and the Covid-19 outbreak in 2020.

History shows that bank share prices have a habit of savagely correcting on the possibility of an economic downturn, even if it’s not ultimately felt.

Before Tuesday’s falls, the banks were trading on an average PE of 14.3, according to Mott, or 11.9 if the top-rated Commonwealth Bank is excluded. This is still in line with the sector’s long-term average.

The time to buy, according to Mott, is not now, when a recession or stagflation is only rated as a 10-15 per cent chance, but when there’s a widespread consensus that either scenario will occur.

By then, the sector’s share prices should have settled at a discount to their long-term average, in a similar way to US banks earlier this year as the likelihood of a recession in the world’s biggest economy began to rise.

The odds have only shortened since then, underscored on Monday by US stocks tumbling in response to a red-hot inflation figure of 8.6 per cent in May, its fastest increase since December 1981.

Concerns about the fragility of the economy spread like wildfire, igniting speculation that the US Federal Reserve could seek to flatten inflation by hiking official rates by 75 basis points on Wednesday instead of 50 basis points.

The bellwether S&P 500 index slumped into bear market territory (a peak-to-trough fall of 20 per cent or more), shedding 3.9 per cent as 495 of its component companies ended the day in the red.

Australia was always going to cop its rightful share of the global rout, and so it panned out with the ASX 200 cratering by 246 points, or 3.6 per cent, to 6686.

The truth is that local stocks – none more so than the major banks – have been defying gravity for months.

The accepted narrative was that interest rates were on a gentle incline, which would fatten interest margins in contrast to the persistent erosion caused by several years of near-zero rates.

As one investor commented dryly: “The pompom wavers for the economy start with the Prime Minister and the Treasurer, extend to the Reserve Bank and include (CBA chief executive) Matt Comyn.

“When (JP Morgan Chase) chief executive Jamie Dimon talks about the global economy, the world listens, and it’s the same in Australia with Matt Comyn and the other major bank chiefs.”

For far too long, the RBA held on to its reassuring pandemic guidance that rates would not rise until 2024, as did Comyn with his own outlier forecast.

CBA’s expectation – until its hand was forced on Tuesday last week by the RBA’s move – was that official rates would glide to a 1.6 per cent peak in mid-2023.

The nation’s biggest home lender dramatically tightened the slack the next day, projecting that the cash rate would reach 2.1 per cent by the end of this year, and that the central bank would cut rates in the second half of 2023.

Since then, any expectations of a benign rate cycle leading to expanding bank margins have been discarded.

The resulting correction has been long overdue.

Like in previous, swift downturns, the true test for the banks won’t be immediate; it will emerge over time as borrowers adjust to higher variable rates and those on cheap fixed-rate loans which are about to expire consider their unpalatable options.

Higher energy and food prices will only add to the pain.

The banks, meanwhile, will stress that borrowers were assessed using serviceability buffers of up to three percentage points higher than the loan rate, that many were ahead in their repayments, and average loan-to-valuation ratios were low.

That’s all well and good, but as any experienced banker will tell you, it’s not the average borrower that matters – it’s the marginal borrower that counts.

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