ANZ Banking: Outlook A Bit Brighter

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About: Australia and New Zealand Banking Group Limited (ANZBY)
by: Dividend Seeker
Summary

ANZ Banking has performed well in 2019, and the broader Australian economy has received a couple of welcome boosts.

With interest rates going lower, ANZBY's dividend continues to look attractive due to its high yield.

While plenty of headwinds remain, Australia will benefit if the U.S. and China reach an agreement on trade.

The Australia housing market is showing signs of stabilizing, and the interest rate cut from the RBA should accelerate that progress.

Main Thesis

The purpose of this article is to evaluate the Australia and New Zealand Banking Group (OTCPK:ANZBY) as an investment option at its current market price. While I was cautious on the Australian banking sector heading in to 2019, I have begun to shift gears and feel comfortable recommending them. Bank shares have recently gotten a boost from an inquiry report that was roundly in-line with expectations, as well the re-election of Prime Minister Scott Morrison, who was seen as the more pro-business candidate. While many of my prior concerns came to fruition, such as labor market weakness and housing price declines, bank shares have held up fairly well, telling me investors are currently more focused on the positives attributes of the Australian banking sector.

While there are undoubtedly pressures facing the Australian economy, the Reserve Bank of Australia (RBA) announced on 6/4 they would be cutting interest rates for the first time in three years, which could provide a boost to equity prices. While it is not a great sign that they felt the need to cut rates, the action itself could help jump-start the economy, by boosting consumer spending and helping spark some inflation. This could also alleviate a prior concern about declining home prices, as lower rates could reverse this trend. Finally, while ANZBY's dividend continues to be pressured by a declining Australian dollar, the yield remains high, and is well above the average dividend offered by U.S. banks.

Background

First, a little about ANZBY. The bank provides a range of banking and financial products and services to retail, small business, corporate, and institutional clients. The company conducts its operations mainly in Australia, New Zealand, and the Asia Pacific region, but it also has a U.S. and U.K. presence. Currently, the stock is trading at $19.50/share and yields 5.8%, based on its most recent semi-annual dividend that was declared in May. During my prior review of ANZBY in February, I was cautious on my outlook for the stock, as well as for the Australian economy in general. While ANZBY has seen its share of volatility so far this year, the stock, along with the broader Australian market, has been performing quite well. In fact, ANZBY is out-performing the S&P 500, the Financial Select Sector SPDR Fund (XLF), and the iShares MSCI Australia ETF (EWA), since 2019 began, as illustrated in the graph below:

Source: CNBC

As you can see, this out-performance is largely due to the price action we have seen over the past month. This has been occurred because of a couple of positive developments within the Australian economy, which I believe provide tailwinds for ANZBY going forward, which I will discuss in detail below.

Interest Rate Cut - The Good and The Bad

I will start by discussing one of the most prominent stories to come out of Australia this week so far, which was the interest rate cut by the RBA. In a statement by RBA Governor, Philip Lowe, a 25 basis point cut was announced, bringing the current rate to 1.25%. This was a significant policy shift, although it was widely expected by the market, because it marks the first cut by the RBA in over three years. Previously, Governor Lowe had stayed away from cuts, insisting the economy was on solid footing. This reversal indicates all was not as well as previously thought, and the Governor highlighted weakening consumer spending and a rising unemployment rate as reasons for the cut.

The implication of this cut is mixed. The fact that the RBA felt it necessary to cut rates indicates there is some definite underlying weakness in the Australian economy, which I cautioned in my February piece. Furthermore, lowering interest rates will undoubtedly continue to pressure bank profits, as it will remain a challenging environment to earn a significant spread between deposits and loans.

However, there are some reasons to be optimistic here. One, the cut could spur economic activity, which will be good for the Australian economy as a whole, as well as banks. Even at lower rates, ANZBY could benefit if consumer spending increases, housing prices climb, and loan activity picks up. Two, as reported on 6/4 by The Guardian, ANZBY has announced it has chosen to not pass on the full rate cut to homeowners, despite other lenders already indicating they will do so. Specifically, ANZBY indicated variable rate mortgages could fall around .18%, rather than the full .25%. While this angered policymakers, it could be good news for the bank, and shareholders. By not passing on the full rate cut, ANZBY should be able to improve its interest margin figure, even with declining rates. Therefore, while some may see this rate cut as a negative for the financial sector, I think ANZBY is in a position to benefit from it.

Housing Slump - Starting To Ease

I now want to discuss the state of the housing market in Australia, as falling home prices across the country was a key headwind I discussed earlier this year. While property prices, in general, continue to fall, there are a couple of developments that make me more optimistic than I was previously.

One, as discussed above, the RBA has cut interest rates, which could provide a boost to the housing market. Specifically, it could help lift asset prices, as potential buyers will now be paying less interest if they lock in the new, lower rates. We could see a renewed interest in home purchases because of the cut, and that could reverse what has currently been months of price declines.

Two, even before the rate cut announcement, property price drops have started to ease. In fact, prices in May dropped by .4% in a month over month comparison from April. While the bad news was the prices continued to drop for the twentieth consecutive month, the good news was the drop was the smallest the market had seen in a year, as illustrated in the graph below:

Source: Bloomberg

My takeaway here is fairly positive. While on the surface this graph looks scary, the fact that the price declines have been moderating consistently since 2019 began is a positive story. Furthermore, this was occurring prior to interest rates declining, so I would expect an acceleration of this trend going forward. Rising home prices should help Australians feel more confident about their finances, lift consumer pending, and also curtail mortgage delinquencies. All of this is good news for ANZBY.

Inquiry Headwind Has Moderated

Another reason for bullishness on the Australian banking sector as a whole is the finalization of the investigation in to banking misconduct by the Royal Commission, with the final report being released back in February. While this has been a headwind for the banking sector for months, the actual release of the report ironically had a positive impact on banking share prices. When the key findings were released on 2/5, ANZBY gained over 6%, with the other banks in the "Big Four" rising by similarly high levels.

While the overall findings in the report did not portray the banks in a positive light, many of the instances of misconduct had been widely reported prior to the release. Furthermore, while some banking practices are expected to change going forward, the primary takeaway was the "Big Four" would remain in-tact, as calls for breaking up the banks largely went unanswered. This moderation appears to have satisfied investors, for now, and does not do much to limit the overall power these large institutions have within the Australian economy. The takeaway here is this matter seems to have been settled for now, removing what was a major, long-term obstacle preventing Aussie bank shares from having sustained positive moves higher.

Dividend Picture Remains Mixed

I now want to touch on ANZBY's dividend, which also presents a mixed bag for investors. On the surface, the dividend looks great, yielding close to 6% at a time when rates are declining and the average dividend yield for a S&P 500 stock is under 2%. While true, the lack of dividend growth has kept ANZBY's yield lower than it otherwise would be, were the bank increasing its distributions at rates similar to U.S. banks. On the bright side, the company has once again kept its dividend stable, declaring an $.80/share (Australian dollars) dividend in May of this year, in-line with the past few years.

While I give credit to ANZBY for not cutting its dividend in what has been a very challenging economic climate for banks, this has not prevented the income to U.S. investors from declining. Due to the U.S. dollar's relative strength against the Australian dollar, the distribution for ANZBY shareholders in the U.S. has been on the decline for the past few years. This is an item I discussed in my last review and, unfortunately, it remains true after the 2019 distribution was announced. The chart below illustrates the trend:

Year Annual Dividend Australian Dollars Annual Dividends U.S. Dollars
2019 $1.60/share $1.13/share*
2018 $1.60/share $1.16/share
2017 $1.60/share $1.22/share

Source: Seeking Alpha

*Assumes second distribution will be constant. Could fluctuate due to changing currency rates.

As you can see, U.S. investors continue to see income declines, and the first semi-annual dividend from ANZBY will likely mean less cash by year-end in 2019 as well.

The upside in all this is that the current income is still high. Furthermore, with interest rates going lower in Australia already, and projected to go lower in the U.S., this income stream will continue to look attractive going forward. While the lack of growth is an obvious issue, the dividend remains a primary reason income-oriented investors will want this stock.

Employment Presents A Risk

While I have just discussed some positive developments within the Australian economy, it is important to remember that the macroeconomic climate remains challenging. While I am more bullish on ANZBY than I was when the year started, I remain cautious, especially since the stock is up over 11% since early February. I believe the shares still represent a decent value proposition, and the dividend is high, but Australia has its own set of challenges. The U.S.-China trade dispute heavily impacts Australia, as China is the country's largest trading partner. Furthermore, while I see potential for a housing uptick, the market is currently in decline, which is putting pressure on consumer spending. Further compounding that reality has been weaker than expected employment numbers, a primary reason for the interest rate cut this week. Consider that Australia's unemployment rate has recently increased to 5.2% (from 5%), and the number of those considered "underemployed" continues to represent a large portion of the workforce, as illustrated in the graph below:

Source: Bloomberg

In fairness, a 5.2% unemployment rate is still fairly strong and, while the number has ticked up slightly, it is still lower than the average rate for the past decade. However, seeing both the unemployment rate and the underemployment rate tick up simultaneously is not a positive metric, and one that investors need to monitor going forward.

The good news is the RBA has taken steps to help address this development, with the interest rate cut. Time will tell what the impact will be, but for now I believe the right conditions are in place to prevent these metrics from worsening substantially from here.

Bottom line

ANZBY has performed well in 2019, yet it remains reasonably priced and sports a high dividend yield. While trade tensions, declining housing prices, and a struggling employment picture all present clouds on the horizon, there are plenty of reasons to be optimistic. One, the RBA has cut interest rates in hopes of spurring economic activity. Two, ANZBY in particular is attempting to profit off this rate cut by only passing along some of the rate cut to customers, in a bid to boost its net interest margin. This is good news for investors. Three, housing prices appear to be stabilizing, with monthly price drops consistently declining so far this year.

While the outlook for Australia is mixed, I see ANZBY as a decent way to play a potential economic turnaround. The pro-business government, coupled with an adaptable RBA Governor, appear poised to boost the economy. ANZBY trades at a P/E under 13, and offers an almost 6% dividend yield, which should entice value investors. While I would not recommend going "all-in" on this stock at these levels, given the positive price action we have already seen in 2019, I do believe the outlook presents a real opportunity. Therefore, I would recommend investors consider ANZBY at this time.

Disclosure: I am/we are long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.