As 2013 draws to a close, the inevitable predictions for how the domestic equity market will perform in the year ahead are starting.  When considering these forecasts and in developing their own expectations, investors should always remember that the performance of the whole is ultimately a sum of the parts.  This is particularly important in Australia where at the time of writing, banking shares represent 31.55% of the ASX100 Index (source: Iress).  The performance of the local banks will thus be a very important determinant of how well the overall market performs in 2014.

So what is the likelihood of the Bank Index repeating the +27.6% return (+34.6% including dividends) enjoyed year-to-date to December 4^th? In our view it is unlikely.

In recent years bank earnings have been resilient and the fully franked dividend yields very attractive, so in a world of low interest rates and cautious investors the demand for bank shares has been understandable.  Admittedly these conditions still hold true today and the ‘yield trade’ theme may well have further to run,  but our optimism is tempered by the following:

• At current prices valuations are full as illustrated by the sector price to pre-provision profit graph below prepared by UBS.  Domestic banks are also trading at significant premiums to global peers on both price / earnings (PE) and price / book (PB) multiples, unsurprising given that nearly three-quarters of the total return has been driven by multiple expansion;

• While the recent reporting season confirmed that earnings remain resilient, top-line revenue growth remains subdued.  Excluding trading and treasury, aggregate 2H13 revenue across the sector rose only 1.7%, with pre-provision profit growth (sequential) per share in fact down -0.2% for the half. With the RBA desperately trying to stimulate the housing market with record low interest rates, it is of course possible that mortgage lending growth improves in the year ahead.  Even if mortgage lending did rise, overall credit growth could actually still decelerate if the trend of mortgages being paid down quicker than required continues;
• Lower bad debt provisions have been a major driver of profit growth, with the entire 2H13 EPS growth for the sector driven by lower bad and doubtful debt provisions.  This is a process which has likely run its course as bad debts as a % of gross loans have fallen dramatically from the peaks in 2008/09. We don’t however expect a rapid deterioration in credit quality (and hence need for increasing provisions), within the next 12 months; and
• The banks expanded payout ratios during FY13, enabling them to increase dividends.  The current sector dividend payout ratio is however higher than pre-GFC norms, and with APRA cautioning banks to limit their payout ratios so that they can comply with the new rules requiring them to maintain higher capital thresholds, further dividend increases will likely require earnings growth.

In conclusion, when assessing the market forecasts you will no doubt see in the next few weeks, make sure to understand what is expected to drive the growth so you can better assess its reasonableness.