The global economic cycle is evolving and equity portfolios need to reflect not just the changes taking place, but where markets are headed next.
As has been well telegraphed, COVID-19 related government stimulus packages will diminish in the year ahead, even as the potential of new COVID-19 variants continue to cloud the future. But overriding both issues will be a rebounding global economy, led by a strengthening US.
That rebound will not last, and by the end of next year the injected stimulus will be largely unwound, and economic growth moderating as the bounce back subsides and gives way to more market led growth. As equity markets are forward looking this scenario will already be priced into expected corporate returns.
With our positive but less robust forward looking return expectations, we have shifted our allocations within equity markets away from the riskiest firms toward those with stronger long-term prospects, higher-quality balance sheets, and a strong outlook for future dividend payments.
In our view the returns that will accrue from growing dividend payments will stand out more clearly against a backdrop of moderating returns. Firms that pay and grow dividends tend to have stronger-than-average financial stability and have a long-term history of posting smaller declines during equity market swoons.
It should be noted, financial stocks seem to be especially sensitive to nominal bond yields. Over time, lower rates have been bad for relative performance. Financials trade especially cheap in more deflationary economies such as Japan and the Eurozone. Presumably this reflects the vulnerability of bank margins to low interest rates.
A reversal of the recent drop in nominal yields should be very helpful for the global financial sector. The historical relationship suggests a move to a US nominal yield of 2 per cent could lead to around 10-15 per cent outperformance.
On the flip-side there’s no reason to be afraid of higher rates, Fed tightening won’t drive catastrophe. Between 2014-18 the S&P 500 had annualised returns of 11 per cent a year as the Fed tightened stimulus, according to Bloomberg data.
Why is there so much focus on growth stocks?
Market forecasters tend to look for the next growth stock, and therefore undervalue dividends and the role they play in determining total returns. We see financials as consistent dividend payers, and we expect Australian banks on average to grow dividends by 5.75 per cent a year in the 12 months to June 30 2023. That would equate to the banks paying out as much as $23.2 billion dollars in dividends.
As a growth investment we see headwinds ahead for the banks.
To ensure diversification, we also like the addition of global banks in investor portfolios, given our expectations of higher rates, increasing vaccinations and economic measures to overcome pandemic related headwinds.
While Australian banks are proven dividend performers, we see more growth potential in other regions, like the US and Europe, as we view Australian banks as fully valued and headed towards a period of margin compression and rising costs.
In the Big Four banks we currently favour Westpac, as we view its model enabling better management of expenses. Westpac is Australia's oldest bank and corporation. It operates a leading banking franchise in both Australia and NZ and has a strong presence in consumer, commercial, institutional banking and wealth. Westpac is a Top 2 bank in Australia by customer numbers and profit in addition to being the largest in NSW.
The case for US Banks
In our view, US banks stand to benefit from a steeper yield curve that should come about as 10-year Treasury yields rise to between 1.5per cent and 2 per cent in anticipation of continued but more moderate economic growth and rising inflation.
Financials have outperformed the broader US market so far this year, and the sector’s relative earnings revisions are running ahead of the S&P 500.
Attractive valuations, announced dividend increases at five of the six largest banks, healthy balance sheets and the Fed’s commitment to strengthening the economy are all positives that leave us overweight on US banks.
US banks to consider could include:
Bank of America (BAC)
We see BAC as a high-quality franchise that is executing well and is well positioned on credit quality and expenses. As they continue gaining share, we would expect BAC to trade at a premium multiple longer term. We believe they are also one of the largest beneficiaries of capital return which should resume in 2021.
Additionally, they are among the most levered to consumer which we think will perform better this credit cycle given the stimulus programs. With the stock trading slightly above the average on our implied cost of equity metric, we think shares are attractive.
Goldman Sachs Group, Inc. (GS)
A global investment banking, trading, and asset management company, with leading market shares across its businesses. Founded in 1869, it is one of the world's oldest and largest investment banking firms. Headquartered in New York, the firm maintains offices in London, Frankfurt, Tokyo, Hong Kong, and other major financial centers around the globe.
The case for European Banks
We see substantial opportunity for banks to benefit from the European economic recovery, particularly as unlike Australian banks, valuations are still relatively modest.
The large Euro banks beat consensus earnings forecasts in the second quarter on average by 31 per cent, driven by better-than-expected revenues, controlled expenses and declining loss provisions. Capital return guidance was generally in-line or better than expectations in the second quarter, driving an aggregate all in-yield of about 7 per cent for the sector in 2021 We expect a similar result next year.
We have revised up full year 2021 estimated sector earnings by 13 per cent this year and 6 per cent next. As with US banks, we are overweight European banks.
European banks to consider could include:
A global financial institution headquartered in the Netherlands. It offers retail, direct and commercial bank products in The Netherlands, Belgium, Germany, Spain, Poland, Romania and Turkey, among others. ING is Europe's "Bank of the Future" and a winner in digital transformation. The bank is well placed to face the challenges of COVID-19, we believe, in terms of relative (to peers) net interest income (NII) stability, cost management and asset quality.
BNP Paribas (BNPP)
In our view, the bank benefits from strong franchises in its three main activities: Retail Banking, CIB and Investment Solutions.
The bank's domestic French retail network is focused on urban, affluent clients. The Belgium retail banking operations are solid and profitable. The bank also has rapidly growing franchises in retail banking overseas. In wholesale banking, BNPP is a leader in European fixed income and has a strong global equity derivatives franchise. We believe management has been strategically bold and also sensible in capital management and the bank is also now undertaking a refocus of its operations.
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