After the sell off on Wall Street on Friday night the Australian Stock market is under pressure today with the index currently down 0.7%. But things could get much worse for the ASX if new research from Goldman Sachs proves correct.
In a note to clients, “Finding value has never been harder”, Matthew Ross, managing director and head of portfolio strategy & quantitative research argues that Australia’s banks, which make up a record percentage weighting of the ASX 200, are vulnerable.
Key to the argument is that Ross says that current pricing for the banks misprices recession risk. Holding this view has resulted in Ross downgrading the banks to underweight from the current neutral weighting.
That means investors and fund managers who follow Ross are likely to sell banks.
With valuations stretched, a low starting point for bad debts and historically high pay-out ratios, we see significant risks to the sector. Unemployment is rising and the second-order impacts of the commodity correction are yet to be felt while macro-prudential and increased capital requirements will slow growth. Our forecast for two further RBA cuts could also put pressure on margins.
There are six key drivers behind the downgrade of his view:
- Employment conditions continue to deteriorate: Ross says that with no signs of stabilisation in the labour market “this increases the the risk that the peak level of the unemployment rate is much higher than we currently forecast.”
- Probability of a recession continues to rise: Goldman believes the risk of recession in Australia is now 1 in 3, a 33% chance. “In addition to a deteriorating labour market, many of the risk factors we highlighted continue to flashing warning signs,” Ross wrote.
- The Banks upgrade cycle is already at an end Ross says. That means that, “Despite ongoing improvements in asset quality, recent results have highlighted weaker pre-prevision profits than we had expected.”
- The RBA and APRA’s trend toward Macro prudential and increased capital requirements is likely to slow the sector’s growth. Ross says that Goldman Sachs expects, “higher mortgage risk weights, higher capital requirements and the announcement of further macro prudential controls.” This will “impact bank growth and returns. Some of the costs will be passed on but Ross believes overall it the changes will lower sustainable growth
- While the RBA rate cuts will impact margins and improve valuations (Goldman is forecast two more cuts in April and July) this won’t be enough to offset the global valuation impact of the start of the Fed’s tightening cycle. Ross expects the impact of Fed hikes in the second half of 2015 will offset and “likely see yield-sensitive sectors underperform”.
- Despite deteriorating fundamentals, valuations continue to rise Ross says. He believes there is a large amount of complacency about the earnings outlook.
“Banks now trade at 14.5x forward earnings, 20% above the 20-year average. In a market that screens as expensive (Resources 15% above average, Industrials 11% above), we feel banks carry the greatest valuation risk in light of the deteriorating macro and their recent strong
performance on earnings.”
It’s a cogent argument and Australia’s large investors who make up Goldman Sachs client base are likely to heed the warning. That in itself could see the banks head lower.