MARKETS

Election uncertainty, rising Covid infections in Europe / US as northern hemisphere winter sets in and a lack of fiscal stimulus have taken the shine off October for markets with only a few trading days left in the month. Over the last two weeks the ASX (-1.18%), S&P (-1.23%) and Nasdaq (-1.59%) have all fell. For the month, the ASX has bucked the trend and is up 4.16%, while the recent market turmoil has moved the S&P and Nasdaq into the red for October. We have talked about market turbulence as we move closer to the election, and this is it to a tee. Post-election, we expect political certainty to stabilise shares, and we also expect a deal to be reached for further stimulus in the US that will provide a boost. Covid outbreaks last roughly 5-6weeks, so the latest wave should taper in November. On the vaccine front a leading candidate has shown promise with the response of their vaccine in both the young and aged cohorts. Eleven vaccines are currently in phase III trials (the final phase before approval).

FRAMEWORK SERIES: Ant Financial and how we value banks, the big four on trial

After a month-long break from bank chatter, it is back, well sort of. Brick and mortar banks are a part of our framework, but we see them as cyclic, and not core. Like a good gold mining stock being at the whims of gold price and currency, a bank stock reacts similarly to overall economic environment.

The big four banks in Australia and Macquarie dominate our everyday financial transactions. The oligopoly that exists in the sector has benefits of stability on a global front, and Australian banks are some of the best capitalised in the world, meaning that they have plenty of ammunition to write loans for customers, as well as ride out the financial storm caused by COVID. A drawback to the sector being dominated by these five banks, is the fact that out of market growth potential has dwindled for the banks themselves, Australians are starved for choice, and competition is low. The banks go where Australia goes economically, hand in hand.

These facts are well known, so how do we choose what banks to back from a share perspective, if any? Despite being some of the largest organisations in Australia, the big four banks have simplified their lending models, with most of the income coming from residential/commercial mortgage lending and a touch of corporate banking. Macquarie is different, as they are an investment bank, but the big four have simplified their operating models. This means when it comes to evaluating banks in Australia, we first look at the macro economic environment, and then we look at valuation.

Macro-Economic Bank Factors

When evaluating the economy in Australia and what drives bank shares, we focus on:

• Regulatory environment: The Hayes royal commission took direct aim at the banking industry and the behaviour of banks in Australia. In the end the outcome was light touch, compared to what was speculated. Still some banks saw their business's damaged. A government or populace that is hyper focused on tougher bank regulations typically is a precursor to softer bank profits.


• Yield Curve Shape: The yield curve represents borrowing rates for different lengths of time for Australian government debt, when put together in a picture, a growing economy slopes up to the right, in a declining economy, the curve slopes down to the right. It makes sense since if you lend someone money over a longer term you would want a higher interest rate if you are expecting growth, if you have low expectations for the economy you would accept less return. What is really important is which way the curve moves, if rates in the longer term (10yrs) are going up that is good for banks, if rates in the longer term are going down and flattening the curve that is bad for banks. Why you ask? Well banks borrow money in the short term (e.g.: term deposits) and lend that money long term for things such as business loans (up to 5yrs) or mortgages (up to 30yrs). Below is the current yield curve in Australia, and as you can see over the last month it has steepened slightly.

• Credit Growth: When we talk about credit growth, we are speaking about the number of loans the bank will make. Loans are assets to a bank, do them right and do lots of them at a high margin and the bank grows its asset base and profitability, do them poorly and the bank may be forced to shut its doors. We mentioned before that the big four banks are tied very closely to the Australian economy, this is where their credit growth comes from. All the advertising, all the deals, offers, etc, etc. At the end of the day, if the Australian economy and housing market is doing well, the big banks are doing well.


• Bad Debts: Think of banking as picking up nickels in front of a steam roller. The steam roller is default. If a bank's default rate rises too high, it wipes out profit. Now a bank with a default rate that is too low is not taking enough risk and expanding credit enough, this is a problem, but a bank with a high amount of bad debt is in dire trouble. Debt default rates follow unemployment. Most folks pay their bills when they can, if someone loses their way of making a living, bills start to slip. Rising unemployment is an indicator of rising defaults, unless the government steps in, such is the case with the current covid19 crisis. The bail out for the unemployed, was essentially a bail out of the banks.

Valuation of Banks

Looking at a bank macro economic story in your crystal ball is difficult, the valuation is easy. All banks are compared to each other on a relative basis based on their share price to book value (P/B) against their return on equity (ROE), then what their dividend yield is.

• P/B vs ROE: This ratio comparison measures profitability of the bank and share price vs other banks in the sector. A bank above the red line is over valued and a bank below the red line is undervalued. If the banks are in the blue box they should all be valued at less than 1.0x book value, since their profitability is below 10% ROE.

• Dividend Yield: Australian banks typically trade between 6-8% gross dividend yield, right now with dividends cut back due to expected losses, share prices have fallen significantly in the banking sector. When profits and dividends are expected to rise, so too will share prices.

Disruption and new players

Our look at banking would not be complete without mention of the world's largest IPO, Ant Financial that is set to debut in early November. Ant is the financial arm of Alibaba (Asia's Amazon). It is more than a bank and has grown from humble beginnings in 2004 as Alipay, to the goliath that it is today. Ant's ecosystem includes over 730million monthly users and touches almost every aspect of Chinese life. Ant is a digital payments company, media distribution, data collection, wealth management, and individual and small business lending platform. Daily transactions dwarf VISA by nearly 800%, at 544,000 transactions per second. The IPO is set to raise $34billion USD for Ant's owners, setting the company valuation at a mind boggling $300billion. Even more appetizing is Ant's potential and growth metrics when compared to competitors, we are looking at revenue growth of 40% last year (Visa and PayPal grew 11% and 13% over the same period). A new era is upon us in the banking world.

If you would like to read more on Ant, please click here for an excellent summary from Mason Steven's.

UPDATING OUR CHECKLIST:

• Valuation: ASX & S&P500 levels: Valuations on the ASX and S&P remain elevated as fwd P/E is now 20.2x and 24.0x, respectively, but they have retreated 4% and 7% since last we wrote. Higher earnings outlooks and a small pullback in share prices at the end of the month are the root cause in the compression of the metrics.
• Global PMIs: Data has softened slightly, but overall, global economies are still recovering well. An example domestically were unemployment figures in Australia coming in better than expected last week.
• Downgrades on guidance: Data that we have seen from reporting companies has been positive or in line with expectations. Guidance is still rare as Covid outbreaks in the US and Europe have kept management team's conservative. ANZ released their full year result late this week and saw positives that clients on mortgage holiday were much fewer than expected and bad debts were lower than analyst predictions.
• Infection rates to slow globally: Australia is under control once again, but Europe and North America are seeing cases rise as temperatures drop in the Northern Hemisphere. This was an expected result; however, markets have tempered expectations as infection rates rise. Positive news from Astra Zeneca saw high immune response from their vaccine to Covid19 infection in adults. The result boosted hopes for the vaccine to be available before the end of the calendar year.
• Monetary and Fiscal stimulus announcements globally: US fiscal stimulus talks are on hold until after the election. The impasse is unfortunate, but when political certainty returns, the US consumer is expected to see a deal done by the new government. All other major regions in the world and domestically have released various forms of relief.

The recent sell off is unfortunate for what was looking like a fantastic October for markets. As mentioned, it was not unexpected as we have a few geopolitical events working in unison against shares. Overall data is continuing to pick up and improve and we inch closer and closer to a viable vaccine that will boost market sentiment. We emphasise again that your advisor has set out a financial plan to meet your long term goals and avoid sequencing risk, where you are forced to sell down assets at a low to meet short term needs. The plan is a guide through the ups and downs of financial markets, and we must keep the long-term goals in sight. If you find yourself with extra investment capital, there is no better time to speak to one of our advisors about investing than today. Take care and we will be in touch again in a few weeks.