Bank on it!

Chief Investment Officer and founder of Aitken Investment Management
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It’s been a very rocky start to the year in global and domestic equity markets, which brings out every doomsayer who never predicted the rally of the last three years.

I think it’s prudent to ignore extremist views. Most have some ulterior motive (selling a product). More often than not, a common sense approach is the right approach.

Straight from the book

In my opinion, what we have seen in developed equity markets is no more than a textbook trading correction. Trading corrections are a necessary part of bull markets that flush out weak-handed/geared money and allow for further market regeneration. They generally bottom out at a minus10% move from the top.

Trading corrections happen with regularity, but in a bull market they are characterised by each trading correction being to a higher low. That is exactly what is happening in developed markets now, and I suspect the vast bulk of this trading correction has already occurred.

No doubt as the FED withdraws QE stimulus this year from the bond markets, we will be in for a more volatile ride than last year, which was one way traffic up. However, the FED is reducing QE stimulus because the US economy is growing (3.2%) and unemployment is falling. This is a good fundamental development.

In the very short term, and one of the triggers for the trading correction, is some US economic data for January has come in weaker than expected. I think this data is an aberration driven by the disruption of the ‘Polar Vortex’ and extremely cold weather in the US. I think this data is best ignored. What interests me more is the momentum the broader US economy ended with in Q4 in terms of GDP growth, employment growth and consumer spending growth.

All in all, despite the trading correction, I continue to view what is occurring as a buying opportunity in the right developed market equities. Quite simply, earnings and dividend forecasts haven’t changed, yet PEs and share prices have fallen. You are simply buying the same forecast earnings and dividend streams at lower prices, which seems a good deal to me.

The local scenario

What you also need to remember in an Australian context is our market will move on from being absolutely dominated by global macro sentiment, to focusing on the company-reporting season. The focus will swing back domestically to earnings and dividends, and I think that will be positive for the Australian equity market, or at worst at least stop the current trading rot.

In my opinion, in this world of continuous disclosure, the bad earnings news always comes out first. The big earnings misses (profit warnings) have already occurred, and while they get headlines because the stock in question falls 30% plus, in my experience these profit warnings are NOT a guide to what will be delivered in the overall reporting season. Note very well there has NOT been a profit warning from an ASX TOP 20 company.

The fact most leading Australian share prices have pulled back by minus 10%, actually means expectations for the earnings and dividend season, in terms of share prices, are quite low. There is now the clear opportunity for a POSITIVE share price reaction to solid earnings and dividend news. I particularly think this is the case for any company that delivers dividend surprise/capital management surprise.

Buy banks baby

In the last few days I have had numerous questions about the banks from investors. There seems to be a growing consensus trading view that it’s “all over” for Australian bank shares. I don’t share that view and believe this is just another buying opportunity for Australian banks. Let me explain why.

Firstly, Australian cash rates are at record lows and will remain there for an extended period as the economy adjusts. But more importantly, major banks are REDUCING the price they pay for term deposits (TDs) and cash management accounts (CMAs), due to the fact they are now holding more capital than they need and loan growth remains subdued.

This is an important point as savers are going to get a nasty shock when they attempt to roll their TDs in the next few months. The chart below confirms the falling average bank term deposit and CMA rates.

Source: Bell Direct

You would have to be extremely bearish on all other asset classes to invest in Australian cash products. At best, you will receive a 0% real rate (CPI 2.7%) and at worst, a negative after tax real rate.

Similarly, if you rely on income to live, you are going to have an increasing problem in terms of bank interest rates. I believe this will lead to continued support for bank shares for two reasons. Firstly, the attraction of high fully-franked income streams for those seeking income, and secondly, earnings and dividend upside on net interest margin expansion as banks pay less for deposits, and roll more and more of their clients on to those new lower rates.

I think this will all be evident on February 12, when Australia’s best bank, the Commonwealth Bank of Australia (CBA), reports record interim earnings and declares a record interim dividend. When that happens, people will refocus on Australian oligopoly bank fundamentals, which remain extremely strong, generating record profits and record dividends, and wonder what all the fuss was about.

Better off in shares than deposits

I believe you are now being paid what I call a very high “equity income risk premium” over unfranked cash to own Australian bank shares. In the table below, I have illustrated our FY14 and FY15 dividend yield forecasts for the big four banks and regionals, alongside the grossed-up value of those dividend forecasts.

Source: Bell Direct

“Equity income risk premium” illustrated.

Source: Bell Direct

Yes, equities are more volatile than cash, but do you think a bank share should yield nearly four times more than a bank deposit at the same bank (pre-tax) to compensate you for that equity volatility? That seems excessive to me, and I want to make sure I use this pullback in Australian bank shares to increase exposure before CBA confirms the strength of the sector on February 12.

I remain very strongly of the view, as I have for the last three years, that you are far better off in bank equities than bank deposits.

So while others are giving up, I am still banking on it.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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