The Wrap: Stretched Banks, Fed Fears & Iron Ore

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Bank valuations looking stretched; the federal reserve may need to do more; Chinese scrap recycling threatens iron ore price; Woolworths winning the online war

-Brokers debate whether the bank rebound has run too far
-Will the Fed need to step up support?
-Rising Chinese scrap recycling threatens iron ore prices
-Woolworths winning the online grocery war

By Greg Peel

Stretched Bank Valuations

Australian banks stocks have been jabbed back into life this month on vaccine excitement, having begun a recovery in October as Victorian lockdowns were eased. Commonwealth Bank ((CBA)), for one, is up 28% since end-September.

In between was bank reporting season, which revealed underlying revenue trends remain challenging (reflecting low demand for loans and margin pressure at low rates), UBS notes, but credit and capital outcomes surprised to the upside (lower bad loans than feared, solid balance sheets).

Since then all news has been positive. Victoria is now out of lockdown, the virus is all but contained in Australia and borders are reopening for Christmas. The government is providing direct support to the housing market and small business employment. Three vaccines are set for approval. Bank dividends are returning to normal and yields are even more attractive in a zero interest world.

The RBA is ensuring mortgage rates will remain low for years. But therein lies the rub. Business credit demand remains subdued as we’re not out of the woods yet, and while mortgage demand has returned, the banks can’t make much money out of them with the cash rate near zero and competition fierce.

Therefore, suggests UBS, material cost reduction is essential. However, none of the banks appear ready to move in this direction. They’re still dealing with remediation costs, increased compliance costs and technology upgrade costs.

Yet a recovering economy and a refocus on dividend yields could yet lead to bank valuations returning to where they were at the start of the year, UBS believes, implying another 10-15% from here.

Macquarie does not necessarily disagree. While noting revenue headwinds are not going away with near-zero rates set to be in place for a long time, Macquarie suggests the valuation discounts that had been applied to the banks can continue to close as bad loan risk continues to diminish in a recovering economy.

To that end the broker is retaining a Neutral stance on the sector, while otherwise seeing the sector as a structural Underweight.

We recall that the banks last put aside massive bad loan provisions while also raising significant capital in the wake of the GFC, only for the Australian economy not to suffer as much as feared. This led to provision reductions and a subsequent capital return bonanza for shareholders – a move the banks came to deeply regret when the Royal Commission made its mark.

The Fed’s Dilemma

Fundamental to the US economic recovery in the September quarter and the surge of Wall Street since April has been the US Federal Reserve’s swift and substantial monetary response. But while the stock market remains giddy on vaccines and a new president, the Fed is more concerned about what’s happening on Main Street.

Namely widespread pestilence and the threat of a de-railed recovery, all without any fiscal support.

The minutes of the November Fed meeting reveal FOMC members were ready to do more if Congress was not, including extending the expiry date of asset purchase facilities for non-government bonds beyond December. Then Treasury Secretary Mnuchin killed off that idea by instructing the Fed to allow the facilities to expire and the funds to be redirected.

While it is true the facilities have been under-utilised to date, the Fed fears the trajectory of the virus and subsequent threat to the economy suggest such facilities should remain ready and willing were conditions to deteriorate, given vaccine distribution remains months away. Even if knowing the Fed is there provides relief simply in terms of sentiment.

The last of the original fiscal stimulus package measures, specifically unemployment support, expire on December 24. Merry Christmas. Rent moratoriums end on New Year’s Eve. If Congress can agree on any new stimulus package before Biden’s January 20 inauguration, it would likely only be (USD) half to one trillion, ANZ Bank economists suggest.

If the Democrats win both Georgia run-offs on January 5, the Senate will be divided 50-50 with the vice president having the casting vote. If so, the package would be more like US$2trn, ANZ believes.

But it’s still an “anything can happen” scenario at this stage, notwithstanding a disruptive and/or disengaged president, thus ANZ assumes the Fed may need to move to increase its purchases of US Treasuries in terms of dollars and/or duration.

Hence lower US bond yields are a possibility once more.

Iron Ore’s Rising Scrap Threat

China has reduced its level of scrap recycling this year but a deeper dive into the market leads Morgan Stanley to believe this trend is about to reverse. The broker expects China’s steel scrap share to increase to 30% by 2030 from 20% in 2020, approaching Japan’s current share of 32%.

The more steel scrap is recycled, the less the need for new steel production, the less the demand for iron ore.

Even before considering Beijing’s emission reduction targets, which would be aided by recycling, Morgan Stanley can see significant iron ore surpluses beyond 2025, which are reflected in the broker’s below-consensus, long-term iron ore price forecast of US$56/t (in real terms).

In a scenario in which almost all of China’s end-of-life steel was recycled, Morgan Stanley could see iron ore being displaced by scrap by 2030, bringing the broker’s longer term bear case of US$45/t into view.

Currently, Morgan Stanley notes, the valuations of most listed iron ore producers are reflecting a long term price of US$70/t or more.

The Online Food People

A survey by Citi points to a material pick-up in Australian online grocery demand, which points a “clear path” towards 10% online penetration – faster than the broker had expected.

In 2019, 11% of shoppers tried online grocery shopping for the first time. In 2020 that figure has been 21%.

Within the survey, Woolworths ((WOW)) beat Coles ((COL)) on every online metric.

Some 70% of shoppers remain resistant to online, Citi notes, citing a preference for shopping in-store and a desire to buy fresh. We won’t address the issue of just how fresh supermarket produce really is. The other determining factor is the additional delivery fee.

Reducing delivery fees would increase online penetration but as Citi points out, fees reflect the cost to the supermarkets of providing a delivery service. Woolworths’ and Coles’ fees are both similar to each other but also global peers.

Citi has Buy ratings on all of Woolworths, Coles and Metcash ((MTS)) but has a preference for Woolworths on superior sales growth, driven in part by online.

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