The Wrap: Stretched Banks, Fed Fears & Iron Ore

Weekly Reports | Nov 30 2020

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.

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