Dear Banker, Please do not mess with Mr Stevens

During the reporting season, Evidente will be providing regular updates of the key themes emerging from company announcements, as well as communications from the government and central bank.

In a busy week for macro news flow, the RBA decided to leave its policy rate unchanged, as was widely expected. In the statement accompanying the decision and the recently released quarterly Statement of Monetary Policy, the RBA confirms that headwinds facing the outlook are likely to persist and that the economy is expected to operate with a degree of spare capacity for some time yet. 

Of course, those monitoring the macro data flow would know that the economy has been operating at well below full capacity for some time already.  The fact that underlying inflation remains at the bottom end of the RBA's target range of 2-3% (and is probably undershooting the target by a long way when upside measurement bias in the CPI is taken into account) and private sector wages are growing at their most sluggish rate since the late 1990s confirms that the economy continues to suffer from a shortfall in aggregate demand.

It should therefore come as little surprise that sectors offering a high earnings certainty and sustainably high payout ratios have delivered above market returns over the past three years.  Consequently, the infrastructure, healthcare, telecommunications and bank sectors are trading on high multiples by historical standards, despite low growth prospects (except for healthcare).

If Mr Stevens is correct that aggregate demand will continue to be deficient (which I think he is), from a portfolio construction perspective, there is little reason to be underweight these sectors despite their rich valuations.  

Of these sectors, the one that continues to polarise opinion amongst portfolio managers is the banks, particularly following the past week in which the sector has shed 7%.  But I expect the renewed price weakness following ANZ's capital raising to be short lived.  The release of APRA's discussion paper a month ago - suggesting that the majors should add around 200 basis points of CET1 capital from their June 2014 levels - was timely and the majors have been astute in being proactive in getting ahead of the curve. 

The pessimists argue that being forced to use more equity in their liability mix will dilute banks' ROEs and undermine their ability to maintain high payout ratios.  However, higher capital buffers reduce the risk profile of the banks, and previous work I have done shows that conservative capital structures encourage banks to have higher payout ratios (see chart below and Evidente's blog post from November 12th 2014). 

Without the ongoing tailwind of lower bad & doubtful debt charges, the strong out-performance of recent years is unlikely to continue.  But I recommend having a small overweight bet in the majors due to the sector's strong dividend sustainability and ability for the banks to surprise the market on cost control.  For those unconvinced, any further price weakness on the back of what I consider to be misplaced concerns about higher capital requirements should be viewed as a buying opportunity.

Global investors have largely missed out on the bank sector's outperformance of recent years, based on their view that Australia's major banks are trading on rich book multiples relative to their global peers.  But those high book multiples persist thanks to high risk adjusted ROEs.  Moreover, based on proprietary work, I estimate that the majors have managed to hold onto the market share gained from the shadow banking sector during the financial crisis.  In contrast, shadow banks in other countries have regained the market share they ceded in the crisis.

Don't mess with Mr Stevens

Indeed, two developments in the past week ought to provide a cautionary tale for investors in shadow banks listed on the ASX.  First, Westpac announced that they would no longer provide funding to payday lenders, including Cash Converters (CCV) and Money3 (MNY).  Second, the outgoing Suncorp CEO acknowledged that when he commenced his role in 2009, Mr Glenn Stevens told him in no uncertain terms how he expected Suncorp to behave (presumably in terms of lending practices and risk taking activities more broadly).

A key lesson stemming from the financial crisis was that prudential regulators need to more carefully monitor the size and activities of shadow banks.  In order to check growth in non-regulated financial institutions, the RBA and APRA are likely to put pressure on the major banks to limit their funding of shadow banks.  Those shadow banks will have little choice but to tap investors for additional equity capital.  This process could potentially end in tears for shareholders, particularly as the regulators are determined to ensure that the aggregate market share of shadow banks in Australia does not recover to pre-crisis levels.  Evidente will shortly be releasing a detailed report on the outlook for ASX listed shadow banks.

The less cautious consumer: Good news for discretionary retailers

The only domestic cyclical sector that I continue to recommend an overweight position in is discretionary retailers, due to their exposure to a less cautious consumer (see Evidente's blog post from May 29th 2015). 

The June retail trade release confirmed that low interest rates and the wealth effect from rising house values are encouraging households to lift spending, particularly in light of the 2.2% lift in spending on household goods.  The modest decline in department store sales suggests that this sector remains structurally challenged, with David Jones and Myers responding with the announcement of strategic and workplace changes designed to adapt their offering to evolving consumer tastes.  The renewed depreciation in the Australian dollar could be a godsend to Myers, as it might encourage some of the global department store chains which opened stores in Australia at a time when the Australian dollar was significantly higher - including Zara and H&M - to exit the country in due course. 

RIO - Don't throw the baby out with the bathwater

Finally, RIO's interim result was well received by the market.  I remain comfortable maintaining an overweight in the stock, despite the prospect of renewed weakness in iron ore prices (Evidente's research report on 10th July contains more detail: Iron ore - Don't throw the baby out with the bath water).  Previous episodes of stagnant commodity prices have been associated with strong market returns from RIO, suggesting that at present, the market continues to under-estimate the company's ability to control operating costs, reduce capex and lift dividends (see chart).