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This article appeared in the February 2015 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

They look fair value given their high dividend yields, but watch for slowing earnings growth. 

Photo of John Abernethy By John Abernethy, Clime Asset Management

Major bank stocks such as Commonwealth Bank, ANZ and Westpac have delivered solid returns in recent years, delivering not just capital gains but also strong dividends in a low-yield environment. In 2014 those gains stalled somewhat, an indication that big gains in bank stocks may be over for the time being.

Indeed, we see a benign environment for banks in 2015, with low economic and credit growth plus higher capital requirements crimping profitability. Earnings growth will be moderate and earnings per share (EPS) and dividend growth will be below recent years.

The X-factor that could hit banks, and indeed the whole market, is an overseas shock to markets.

Australia's major banks have gained a reputation as highly profitable and solid-yielding stocks. In 2012 and 2013 investors seeking both safety and yield pushed their prices higher. Profits also grew on the back of strong growth in mortgage lending particularly.

But 2014 was a mixed year for returns. Most of the major banks' share prices finished the year broadly flat or even drifted lower. The exception was Commonwealth Bank of Australia, which outperformed.

A number of factors have crimped share price gains, including the soft Australian economy and the looming threat of the David Murray-led Financial System Inquiry, which has called for greater capital requirements for banks.

(Editor's note: Do not read the following ideas as stock recommendations. Do further research or your own or talk to a financial adviser before acting on themes in this article).

Low economic growth in 2015

As for the Australian economy in 2015, we see a very, very low growth but benign situation for banks. Interest rates are low and so there is no immediate pressure on borrowers.

We expect the economy to grow by only about 2 per cent in real terms, and unemployment increasing. The question is whether rising unemployment will affect loan and mortgage repayments, as well as increasing growth in arrears and non-performing loans. If it does, we expect it to show up in the second half of the year.

Few drivers of credit growth

We expect few drivers of credit growth. In small-business lending, National Australia Bank has become more aggressive but we do not think there is a lot of support across banks to lend aggressively to small business.

In personal lending, while credit cards are high margin they are also high risk and banks are not going to push them aggressively.

Corporate lending should also be relatively muted. World markets have opened up again for big businesses to borrow and it is really only mid-cap companies that need to use bank funding.

Behind-the-scenes discussions

We see greater requirements of capital impeding return on equity (ROE) growth. The major banks will have to raise more capital or retain more capital from profits.

There are probably behind-the-scenes discussions with the regulators suggesting the banks should be careful in terms of the extent of mortgage lending and leverage against property. That should slow the rate of growth of mortgage lending.

The result of a low-growth economy and higher capital requirements for banks is that profits will grow but at a slower rate than in the recent past. We believe the major banks will grow profits around 3 to 5 per cent.

Higher capital requirements will also hurt dividend payouts. Although dividends will not fall, like profits we think they will grow at a slower rate - around 2 to 3 per cent.

Risks of an external shock

Of course, the big unknown is the chance of an external economic shock that rocks asset markets, which in turn destabilises consumer and business sentiment.

There has already been a sharp slump in oil prices, reflecting economic weakness in Europe, and significantly increasing economic and political risks in oil-producing nations and regions such as Russia, South America and the Middle East.

There is also the risk of a bond default triggering a major correction in developing and emerging world credit markets. That could create a contagion effect where the negative shock spirals into other markets and regions, as we saw during the Asian financial crisis of 1997-99.

Perhaps the biggest potential risk is a savage bond market correction, particularly in the "sub-prime bonds" of Europe.

A major market correction could damage domestic sentiment, which could flow through to falling consumer spending and cut demand for credit and business investments. That would hurt the major banks.

National Australia Bank (NAB)

Looking at the banks individually, NAB offers the best yield. We forecast it to pay a fully franked dividend of $2.07 per share in 2015. With its shares trading at $33.92, that translates to a healthy dividend of 6.1 per cent.

NAB's performance has been hurt by its underperforming legacy assets in the US and UK, which it is getting out of. It has been offloading its higher-risk loans from its UK commercial real estate portfolio, and has begun the sale of Great Western Bank through an IPO.

Commonwealth Bank of Australia (CBA)

CBA is the highest-priced stock among the major banks and the most overvalued according to our research. At $86.19 it trades above our current valuation of $77.17 and has a forecast fully franked dividend yield of 4.8 per cent.

CBA's price reflects that it is the most profitable of all the major banks and is one of the best banks in the world on any metric. But that price increases risk. We believe CBA is entering the peak of its earnings cycle and current performance should not be extrapolated into the future.

We would like to see a pullback in CBA's shares by around 10 per cent before we were interested.

Westpac (WBC)

At $33.02, Westpac is trading at fair value and in line with our current valuation of $33.65. With a forecast fully franked dividend of $1.90, its yield is around 5.6 per cent.

Westpac has a strong domestic franchise, a conservatively underwritten loan book and, through its 60 per cent holding in BT Investment Management, exposure to the upside from the growth in superannuation.

ANZ

We believe ANZ provides the best value among the major stocks. At $32.22 it is trading below our value of $36.45, with a forecast yield of 5.9 per cent.

ANZ is successfully rolling out its strategy of developing into a super-regional bank, with a growing presence in the Asia-Pacific region that exposes it to the clearest growth cycle for investors: the expansion of Asia's middle classes.

That regional diversification helps buffer the bank against domestic risks, including the slowing economy and higher capital requirements. While it is diversifying into Asia, its core Australian and New Zealand operations continue to perform well.

ANZ is also well capitalised and reinvests a higher proportion of earnings than the other banks, so grows its intrinsic value faster.

Overall, we think the major banks are fair value given their yield. We do not think there will be significant earnings growth, and they should hold prices unless there is an external shock.

About the author

John Abernethy is Chief Investment Officer at Clime Asset Management, one of Australia's most respected fund managers. For weekly macro-economic insights, market commentary and invites to exclusive events; sign up for Clime's WEEKLY Investing Report.

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