Aussie Banks & the Debt Crisis
The following piece titled “Banks go badly with flat yield curve or debt crisis, we face both” by Damien Klassen (Head of Investments at the Macrobusiness Fund) talks to his view on Aussie banks but it is an excellent summary of the challenges faced by the Aussie economy at a time when there is seemingly a growing feeling that we will get through this with a V shaped recovery. Breaking from tradition we are repeating it verbatim given it is already succinct and insightful.
“What’s our medium to long-term outlook on Australian banks?
We are not positive on Australian banks in the medium term.
Australian banks will have a time to shine again. That time is not while staring down the barrel of the highest unemployment rate seen since the Great Depression and an extended period of close to zero interest rates.
These are not company-specific issues, rather the banks are facing incredibly challenging macro-economic conditions on two fronts.
The first front is the risk of a debt crisis coming either through business lending or a housing market crash.
Even if banks somehow manage to avoid the effects of a debt crisis, they are facing a second front of an extended period of low interest rates.
Neither are attractive for banks: The acute crash of a debt crisis, or the chronic grind lower of low interest rates.
The damage is already done from the shutdowns. Even if there was a coronavirus cure tomorrow, we are facing:
- Mass unemployment. Unemployment tends to take years to recover.
- Depressed wage growth, held down by high unemployment.
- A demand shock from consumers looking to increase savings.
- Our economy has been driven for a decade on the willingness of consumers to increase debt at growth rates far higher than income growth. We are expecting low debt growth at best, more likely to be negative.
- Companies that are looking to deleverage. Meaning lower profits.
- Companies that are looking to increase the slack in their supply chains. Meaning lower profits.
- Companies and governments looking to repatriate supply chains to reduce reliance on imports of critical medicines, food or equipment. Meaning lower profits.
- Small and medium businesses going broke.
- Falling rents, dramatically reduced immigration, reduced student numbers, increased vacancy rates all weighing on property prices. Property prices are likely to drop significantly.
- Banks increasing credit checks and decreasing credit availability.
There will be offsets. There will be government stimulus. But these will reduce the depth of the downturn, not prevent a downturn.
- Australia (through commodities) has leverage to world growth. When world growth is good, Australian growth is very good. But when world growth is bad, Australian growth is very bad. World growth is not good.
- Australia started with the 2nd highest consumer debt loads in the world. This makes Australia, and Australian banks, more susceptible to a debt crisis.
- China is still operating 10-20% below pre-crisis levels. i.e. Australia’s largest trading partner, after months of being open, still has 10-20% less demand for goods and services than a year ago.
So, Australia has all of the ingredients for a debt crisis. Will we manage to avoid one? It seems unlikely.
Extended low interest rates
The Reserve Bank of Australia has explicitly guided to keeping interest rates low for a long period of time. The general theory is the RBA wants to get more economic activity to decrease unemployment and lift inflation. By lowering the interest rate:
- Consumers with home loans save money. For a small proportion, this means that they can afford higher house prices and so bid up the value of existing houses. For other consumers with home loans, the cost savings and the confidence from higher house prices translate into greater consumption spending.
- It becomes cheaper for businesses to borrow to invest. The mix of more consumer spending and less expensive loans means that more firms invest.
The combination of the two is a virtuous circle that then employs more people, which creates more consumption and more business investment and so on.
However, these are reliant on three expectations:
- Banks will lend more money as interest rates fall.
- Consumers will be confident enough to take out the loans
- Businesses will be confident enough to take out loans and expand
The problem is banks have different incentives in their business model: low-interest rates are not necessarily better. If interest rates are too low, it can be a disincentive for banks to lend. As we have seen in both Europe and Japan.
At the simplest level, banks are an asset/liability mismatch. In essence, banks borrow from depositors (and others) on a short term basis and lend it out for long periods.
So, banks make the most money when short term rates are low (borrowing is cheap) and long term rates are high (lending is expensive). This is called a steep yield curve. The actual level of interest rates is far less important than the difference between the two interest rates. But, as many depositors know, banks stopped paying interest on most transaction accounts a few years ago. So banks can’t lower interest rates on those accounts any further to reduce costs. This means lower rates don’t decrease bank costs for at least part of a bank’s liabilities.
The other part of a bank’s liabilities is more complicated. The short version of the story is yield curves are very “flat” (rather than the profitable steep curves), and so there isn’t much relief on that front either.
The net effect: rates cuts for banks are going to eat into profitability. Europe has been facing this conundrum for years. How do central banks keep rates low enough to stimulate the economy but not send the banks bankrupt? And that is where Australia now finds itself.”
Klassens goes on to talk more about equities more broadly. The takeaway though is clear, there is no easy way out of this crisis. Whilst Australia may have fared (so far) better than most, there are structural changes that don’t simply ‘rebound’ and we are inextricably linked to a much messier global economy. Now is not the time to be complacent. At the extreme end of where his thesis on Aussie banks might end, it may also be a time to be thinking about cash in the bank as opposed to holding real money, gold and silver, instead. We talked about this most recently in our article ‘SAFE AS A BANK’ & ‘BRICKS AND MORTAR’ V GOLD – THE COUNTERPARTY CONUNDRUM and it is a must read.