Tony featherstone on which banks he favours

Some investors might be surprised that the United States business cycle has turned expansionary, given unrelenting doom and gloom in the media.

The OECD Leading Indicator for September 2020 shows the US following China’s lead with its progression to expansion. The indicator shows turning points in business cycles.

That’s good news for equities. Every economic indicator is imperfect, but this one has a higher correlation with Australian shares. It partly explains why shares have rallied this month.

The Composite Leading Indicator (CLI) for the US in September is almost back to where it was in February 2020 (98.6 versus 99.4). Turning of CLIs tend to precede turning points in economic activity to trend by six to nine months. That suggests an improving US economy next year.

Much can go wrong, of course. The US Presidential election in early November is a source of market volatility. Don’t write off Trump being re-elected. Opinion polls on his prospects have been unreliable, but he’s running out of time to close the gap with Joe Biden.

Also, the OECD noted that its indicators imply global economic growth will remain below trend. With more European countries implementing second lockdowns, and US COVID-19 cases staying high, it won’t take much for the CLI to moderate.

Implications for Australian investors

With CLIs for China and the US in expansionary phase, it’s no surprise that Australian resource stocks have outperformed the share market this year. Stronger global growth (albeit off a lower base) is good for cyclical growth companies, such as commodity exporters.

I wouldn’t sell resource stocks just yet. I have been bullish on BHP and Fortescue Metals Group in the Switzer Report this year and continue to like their prospects as Chinese growth recovers.

If the OECD’s leading indicator is right, the resource rally should have further to run. But at some point in the next quarter or two, more fund managers will rotate from growth stocks that will look expensive into value stocks that have underperformed this year.

That’s good for banks. To recap, I became positive on Australian banks in late April in this Report, having fortuitously avoided the sector for five years. (‘Bank on the banks’, April 29).

It was such a contrarian view at the time (COVID-19 fear was peaking) that the Switzer team asked me to explain the idea to readers in more detail in a webinar.

The S&P/ASX Bank index has rallied about 20% since that column. ANZ Banking Group, my preferred bank stock (it still is) is up 24%.

Yes, bank dividend cuts have hurt and long-term investors in banks are suffering. The one-year total return in the S&P/ASX Bank index is -26%. The ASX 200 has lost 6% in comparison.

Over three years, the annualised total return for banks is -12% and over five years it is -6.4%. A slightly negative annualised return for the banking index over 10 years highlights the sector’s lost decade for investors.

That underperformance won’t last forever. In April, I thought the market’s view on bank bad debts during COVID-19 too pessimistic. Bank valuations implied the market thought tens of thousands of home borrowers and small businesses would go bust during the pandemic.

I wrote in April:  “I am less bearish on the economy over the next 12 months than some forecasters and do not believe banks are underestimating likely loan impairments or that bad debts will soar beyond expectation.” So far, that is the case.

Progress on loan repayments

The Commonwealth Bank’s announcement this week on COVID-19 temporary loan repayment deferral data for September 2020 provides fascinating insights into the economy.

CBA, the country’s largest home lender, provided temporary repayment deferrals on approximately 250,000 home and business loans. That put a big slice of its loan book at risk.

Like other banks, CBA has been busy working with customers as they approached the end of their initial six-month deferral period. Total loan payment deferrals were 129,000 in September, from 210,000 in June. Total balance on deferred loans was $42 billion, from $67 billion in June.

Simply, more people than expected have started repaying their loans. That’s a good sign for the economy and particularly for banks that risked higher impairment charges and bad debts if more Australians defaulted on their loan. The market was too bearish on impairment levels.

But banks aren’t out of danger yet. CBA still has 31,000 loans to small and medium-sized enterprises (SMEs) in deferral, worth $4 billion. About 28,000 of these deferrals expire in October, meaning CBA and other banks will have to extend lots of SME loan-repayment programs.

The Reserve Bank last week warned that thousands of small businesses will fail and financial distress in households will rise in coming months when loan deferrals end and government wage subsidies and higher unemployment benefits taper or end.

The big swing factor is Victoria. The longer the State stays in this lockdown (I live in Melbourne), the shorter the odds of SMEs and households with loan deferrals going bust.

COVID-19 cases are still too high for the Victorian Government to move to most of the next stage of restrictions easing (from this Sunday). So, this insane lockdown continues.

A second COVID-19 wave in New South Wales is another risk.

Nevertheless, loan-deferral data is unambiguously better than markets expected. More borrowers are starting to repay their home loan again, either because their employment situation has improved or they have a sufficient savings buffer.

I suspect the market underestimated the magnitude of government subsidies and handouts, and the effect of superannuation withdrawals on consumer savings. Clearly, a lot of homeowners have squirreled money away this year and are able to meet their repayments again.

I also believe SME loan deferrals will be better than the market expects. Insolvency experts are bracing for a flood of business failures next year, but those fears might be overstated.

Government subsidies such as JobKeeper and the cashflow tax boost have been remarkable for small business. The Federal Budget included more generous asset write-off provisions and the ability to carry back losses against tax paid on previous corporate profits.

The jump in Westpac’s consumer sentiment survey this week showed Australians believe the budget will improve their financial fortunes.

SMEs, particularly retailers, still have plenty to worry about. But the amount of government stimulus means many SMEs have built up their cash buffer. That won’t save them if State borders remain shut, but more should be able to repay their loans again.

Time to add to bank exposure

Better-than-expected data on loan deferrals over the next few months will be the catalyst for a larger rally in bank stocks in the first half of 2020. As will fund managers rotating some of their portfolio out of pricey growth stocks into undervalued banks.

From a technical-analysis (charting) perspective, bank stocks look like they are getting ready to break out of their accumulation (sideways) pattern, breach resistance and head higher.

Not for a minute am I suggesting bank share prices will take off. Margin pressure (from a further cut in interest rates in November) and limp credit growth (from a recessed economy) will offset much of the gains from improving loan-deferrals data and lower-than-expected bad-debt levels.

Moreover, I expect full-year bank results in the next few weeks to provide little joy on the earnings or dividends front. Prospective bank investors need patience – at least a three-year outlook.

Nevertheless, the bank interim reporting period in the first half – and all the gloom that came with it – provided an entry point to buy stocks. The same could occur after the full-year results in the next few weeks.

Several factors could drive bank stocks lower in the next few weeks. A Biden result in the US Presidential election could weigh on US bank stocks, which tend to be correlated to Australian banks stocks. Presumably, the market has factored in the higher probability of a Biden win, but there is scope for election-related volatility for US bank stocks.

Risk aside, it won’t take much for more capital to move back into banks, as fund managers position for the next stage of the recovery.  As such, I remain positive on the big banks.

My preferred ideas remain ANZ (the best-governed bank) and Westpac Banking Corporation, which has fallen more than the other big-four banks over 12 months. Then, National Australia Bank. CBA is the best performer, but its share price is closer to fair value.

Chart 1: ANZ

Source: ASX

Morningstar values ANZ at $25 ($18.98 as I write this column), Westpac at $25 ($18.55), NAB at $25 ($18.99) and CBA at $71 ($68.61).

Morningstar’s earnings assumptions and valuations for ANZ, Westpac and NAB look reasonable, meaning there is still a sufficient margin of safety to buy them.

Increasing exposure to the banking sector via the VanEck Vectors Banks ETF (MVB) also makes sense for investors seeking long-term, diversified exposure to banks in their portfolio core.