Is it time to sell your bank shares?

The Australian economy is tipped to slow – more than expected.

According to the government’s Mid-Year Economic and Fiscal Outlook (MYEFO) released today, the budget is expected to blow out by another $26.1 billion over four years and long-term growth forecasts have been downgraded – from the forecasts just six months ago!

Indeed, sliding commodity prices and a transitioning Chinese economy will take their toll on Australia. Our net debt is expected to grow to $263 billion (from the $201 billion forecast only six months ago) in the next 10 years. A balanced budget will not arrive until 2020-2021 – a year later than previously forecast.

Is it bad news for the banks?

A slowing economy is bad news for bank stocks because lower growth expectations can adversely impact the willingness of private enterprise to invest. Eventually, slower economic growth trickles through to business confidence, employment levels, and consumer purchasing decisions.

Tougher times ahead

After more than two decades without a recession, Australia’s economy has risen on the coat tails of Chinese growth for many years. The following chart was used by Dr Martin Parkinson PSM, Secretary to the Treasury, during a speech in 2014:

Source: - speeches

Source: – speeches (period without a recession)

It’s been 24 years and three months since Australia’s last recession. At that time, Westpac Banking Corp (ASX: WBC) nearly went bust!

Is it time to sell bank stocks?

As alluded to above, confidence flows in a vicious cycle. Sharemarket’s – fickle at the best of times – swing profoundly in both directions. They will overshoot at the top and stay lower for longer.

During the boom times, credit (i.e. debt) becomes widely available. Investors will use leverage to accelerate returns, with the banks taking a slice of profits for acting as the intermediary between creditors and depositors.

It’s worked well for Australia’s biggest banks – Commonwealth Bank of Australia (ASX: CBA), Australia and New Zealand Banking Group (ASX: ANZ), Westpac and National Australia Bank Ltd. (ASX: NAB) – which have grown their loan books at very impressive rates over the past two decades.

The ongoing economic growth has kept credit quality high; while two decades of falling interest rates (from the mid-teens to just 2% per year) have aided in keeping bad debts low, but the debt levels in households are near record highs.

House prices, fuelled by the macroeconomic factors above, but also net migration and supply constraints; have run to eye-watering levels.

Data sourced from S&P Capital IQ.

Data sourced from S&P Capital IQ.

In the wake of regulatory changes, which hinder asset (i.e. loan) growth, Australia’s biggest banks turned to investor loans, superannuation, and business banking. However, these lines of business are not as lucrative for the banks as the mortgage markets of Australia and New Zealand.

The big four banks are believed to control around 84% market share of housing loans in Australia. However, recent changes to risk weightings on investor loans — which, by the way, have also been capped at 10% per year — may enable regional banks like Bank of Queensland Limited (ASX: BOQ), Bendigo and Adelaide Bank Ltd (ASX: BEN) and Suncorp Group Ltd (ASX: SUN) to play catch up. In recent times, bank chiefs have warned of growing competition in domestic credit markets.

Is it time to get out?

Fortunately, unless Australia experiences some unforeseen economic event, the chances of a recession appear low. However, recency bias is the tendency to believe trends or patterns will continue in perpetuity. Simply because Australia hasn’t undergone a meaningful recession in the past 25-odd years, doesn’t mean we are immune to experiencing one again soon.

More specifically, due to their size and current valuations, the banks will require solid growth for many years and no unforeseen economic slowdown to uphold their current valuations. Indeed, bank shares appear priced for perfection, in my opinion.

Therefore, if your intention is to beat the market in the next three to five years, my advice is to make sure you’re not overexposed to the sector. In addition, if your investment horizon is more than five years, you should consider using any profits to invest in cheaper ASX shares, or diversify abroad.

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Motley Fool writer/analyst Owen Raszkiewicz has no position in any stocks mentioned.

Owen welcomes your feedback on Google plus (see below), LinkedIn or you can follow him on Twitter @ASXinvest.

Unless otherwise noted, the author does not have a position in any stocks mentioned by the author in the comments below. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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