The coronavirus is driving a perfect storm for all types of investors. Those focused on capital appreciation have suffered as risk assets have been subjected to one of the fastest bear markets in history. Those focused on yield are also suffering as the outlook for corporate earnings signals a substantial decline in dividends is on the way (not helped by substantial capital dilution that is working its way across the market).
Unfortunately, we see little way to avoid a hit to income from a pending decline in dividends. This is because very few stocks will be immune to the economic growth slowdown, either domestically or via international linkages as the ratio of recent earnings downgrades now illustrate. Even traditionally defensive areas such as infrastructure, property, telco’s and toll roads are expected to be hit by the economics of a “sudden stop” with potential dividend cuts on the cards.
Even more worrying for Australian retail investors is the decision by Europe, UK and NZ regulators to temporarily stop banks from paying dividends, with talk now shifting to whether this could also occur in Australia. At present the banks comprise around onethird of all dividend income paid (~$24bn in CY19), which would mean that a potential halt, even if only temporary, would represent a significant cut to dividend income levels on top of the hit to capital values suffered since late February.
In addition, dividends have been largest contributor to market returns since the end of the GFC (~50%), ahead of P/E expansion (37%) and earnings growth (13%). This would suggest any decline would has the effect of also lowering the total return potential of the Australian equity market particularly given corporate Australia’s poor track record of generating earnings growth as an offset.
The good news is that we expect dividend income to bounce back, although we believe it will take between 12-18 months as corporates first chose to rebuild cash buffers and even longer to reach peak payments in the 2019 year. Similarly, the potential to set a more conservative payout ratio as a result of uncertainty around the outlook could impact how quickly corporates revert to historic payment levels which adds to the drag on dividends in coming years.
In addition, outside of APRA’s 1/100 year bear case economic scenario, Macquarie’s banks team think the sector can sustain their dividends, albeit at reduced payout ratios as is reflected in the cuts to dividends built into forecasts in coming years.
APRA’s bear case stress test remains some way from Macquarie’s’ economic reality.
In 2017 APRA set out a bear case stress test to gauge the extent of potential losses should there be a material and sustained economic downturn. The scenario was built on a global economic shock, leading to a 4% decline in GDP, ~11% unemployment and a 35% reduction in house prices.
Applying projected key loss rates across the majors’ portfolios results in a cumulative loss of ~$137bn over five years and a peak level of losses of ~$38bn (2x higher than adjusted peak loss rates during the GFC). Under this scenario, Macquarie estimate that banks will need to raise $5-10bn of equity each, although these amounts could be reduced if banks cut dividends aggressively and early in the cycle.
We do not think the scale of these loses is plausible under the current shock due to the offset provided by fiscal and monetary policy support. Taking account of this policy stimulus, Macquarie estimates cumulative losses would be ~$25-27bn which is 25% below APRA’s stress test scenario. Even under this scenario banks would need to materially reduce their dividends and raise additional capital, but by suspending dividends early in the cycle, they could potentially manage their way through without additional capital.
Not to oversimplify the current situation, outside of a APRA directive, the outlook for dividends will rest with the assessment of the economic downturn and should it remain deep but short, Macquarie is comfortable that banks can sustain our forecast dividend outlook. But, we do not have transparency on how Bank Boards might treat the need to protect capital given the risks around the outlook which is fluid and changing by the day.
What should an investor do with banks stocks?
- We are not expecting bank dividends to go to zero. We think this would only be necessary under an extremely bearish economic scenario with no offsets from fiscal / monetary stimulus. While APRA could issue a directive to suspend dividend payments, current guidance is for Bank Boards to make this decision. Our bank team thinks bank dividends will rebase at a lower, more sustainable levels.
- While bank dividends are expected to fall, banks still have relative appeal for income investors in the current market. COVID-19 has negatively affected almost every sector including typically defensive income areas. Companies have cancelled, suspended or deferred dividend payments to preserve capital with Macquarie’s analysts have assumed nil dividends for several of these companies for at least the next year (see “Investment Strategy Update #15: Dividend decline is temporary”). Relative to these more troubled sectors (toll roads, REITs) we think bank dividends look relatively attractive.
- Macquarie does not see significant potential dilution risk for the banks. In our bank team’s stressed scenario, capital positions would fall below 10% without any other capital management measures. Assuming the regulator would look for banks to keep their capital positions at ~10% minimum, the majors would need to raise up to $10b of capital each. While we don’t believe this will be necessary due to significant stimulus, some level of equity issuance (e.g. DRPs) is likely to limit any potential for dividend growth.
- The major banks (ex CBA) are trading at historically cheap valuations. ANZ, NAB and WBC are all trading < 10x consensus earnings while CBA has maintained its premium on ~14x due to its superior capital position. While the rest of the market is also trading cheaply, the chart below shows relative valuations (ex CBA) are testing previous lows. While banks no longer have the same earnings growth potential as in the past , even allowing for this we think valuations look reasonably cheap, and recommend holding onto bank stocks rather than selling at depressed levels.
- Which banks would be most vulnerable in a downturn? The impact on bank earnings is material in a bear case scenario, but it’s important to recognise each bank would still remain profitable. ANZ would see the sharpest losses due to a higher proportion of institutional and unsecured loans. While NAB has a high proportion of SME loans we note 75% of its SME book is secured with an additional 21% partially secured. CBA would weather the storm better than peers due to its high return structure having a bigger buffer to absorb losses while WBC would experience similar losses to CBA due to its mortgages bias.
What are the alternatives?
We think yield investors need to tread extremely carefully in the current market. Many companies trading on apparently high dividend yields are cancelling dividend payments to preserve cash as revenues evaporate. We don’t think yield investors will be able to preserve income in the current market. Attempting to do so by selling the banks for higher yielding banks could end in disappointment.
Defensive yields from essential areas of the economy are the only reliable source of income until we have better visibility on the growth recovery. In the current market this only includes utilities, consumer staples and telco’s with the usually defensive yield sectors of healthcare and REITs facing too much disruption. We highlight Telstra (TLS), APA Group (APA) and Spark Infrastructure (SKI) which all yield at least 5% while Woolworths (WOW) and Coles (COL) offer a 3% and 3.5% yield respectively.
Key investment takeaways:
- Offshore bank regulators have directed banks to suspend dividend payments immediately. In Australia, APRA’s current guidance is for Bank Boards to determine dividends.
- Under a bear case scenario, the banks would need to raise ~$5-10b equity each and cut dividends aggressively. However, stimulus measures are a significant offset and we view this scenario as unlikely in the current downturn.
- Dividend payments are forecast to continue trending lower. Outside of a bear case economic scenario, Macquarie’s banks team thinks the sector can sustain dividends, albeit at reduced payout ratios.
- We do not think investors should sell or switch out of bank stocks in order to preserve dividend income. Bank valuations are cheap and attempting to preserve income levels will be highly risky with almost every sector affected by COVID-19.
- Alternative sources of dividends are possible, but investors need to tread carefully till we have more visibility on the growth trajectory. For now, we recommend sticking with essential services such as utilities and consumer staples rather chasing high yield stocks.
Jason and the Investment Strategy Team