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Investment Strategy Update #47

Australian Banks – In a sweet spot

• Australian bank stocks are in a sweet spot where banks offer a sensible hedge against this backdrop. both macroeconomic and stock specific factors Rising long bond yields and a steepening yield curve are providing a strong tailwind for further are positive for bank margins which have been performance. crushed by low rates and a flat yield curve.

• Despite a rapid valuation re-rating since October In addition, as the economy has reopened, for the 2020, we see more upside as earnings (and most part faster than expected, and the housing dividends) continue to be upgraded and as the market has responded to policy initiatives and low sector benefits from a steepening yield curve, borrowing rates, the bear case for banks has been lower than expected bad and doubtful debt quickly unwound and we think the earnings and charges, improving credit demand and a reversal dividend upgrade cycle still has some way to play out. of underweight positions as reflation drives Investor sentiment has also shifted since 4Q20, with further value stock rotation. institutional investors closing their underweight positions, with rising dividends expected to further • Macquarie upgraded banks’ earnings by 10-25% through the recent reporting season. For a large- stimulate retail investor interest. cap sector, this is substantial, and while medium- Relative price performance improving term structural challenges remain, there is still Banks versus ASX200 scope for additional valuation expansion. $ Relative Price vs EPS Performance 130 • Macquarie’s order of preference within the sector 120 is ANZ Bank (ANZ), Westpac (WBC), National 110

Australia Bank (NAB) and Commonwealth Bank 100

(CBA). ANZ and WBC are benefitting from low 90 impairment charges and strong capital 80 provisions, while relatively high multiples limit 70 CBA’s scope for upside. Relative price index 60 Relative EPS index We upgraded our view on banks back in October 50 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 2020 (see Investment Strategy Update #30: Australian Source: Factset, MWM Research, February 2021 Banks – the start of a new beginning, 12 October 2020). Since then, banks have risen 29-55% buoyed Positives continue to stack up for banks by both macroeconomic and stock specific factors. While bank stocks have already seen a significant We believe the following factors have contributed to valuation re-rate over the past 5 months, we continue the banks’ improving performance and will continue to to think they offer stable upside – supported by a provide ongoing support for share prices and re- multitude of positive tailwinds – along with the rating: prospect of even higher dividends payments. • Dividend cuts have abated and are returning to While the market has been spooked by rising rates sustainable levels. We have now passed dividend and the potential for an inflation outbreak, we think trough levels, with banks having rebuilt their

capital buffers and impairment charges being housing, with expectations of 10-12% growth written back. Banks offer an attractive yield through to the end of 2022. premium to the broader market, and we see a more sustainable yield for the sector at ~4-6%. • Substantial valuation cushion for BDD’s and downside risks: Initial expectations around Furthermore, while bond yields are rising, banks’ unemployment and BDD’s have proven to be dividend appeal is likely to support share prices in overly pessimistic particularly given the support of an environment of low-interest rates. As the a “Team Australia” government, with banks’ market is again focusing on the possibility of restored capital positioning providing scope to higher rates, banks provide investors with a deliver lower BDD charges in future periods. hedge with higher margins a strong tailwind to Macquarie believes a ~25% better impairments reduced relative attraction on a dividend-bond experience than currently forecast should provide yield basis. In general, if rising bond yields are the ~2-4% upside to existing fundamental valuations result of cyclical improvement, then banks are for the majors (biggest for ANZ/NAB and smallest likely to outperform the broader market. for CBA).

Dividends are returning to sustainable levels Banks are still relatively cheap

DPS of Banks relative to ASX200 x Relative P/E - Banks vs. ASX200 (12 month forward) 120 1.00

110 0.95

0.90 100 0.85 Forecast 90 0.80

80 0.75 Bank P/E relative to ASX200 0.70 70 20-year average 0.65 60 0.60 10 11 12 13 14 15 16 17 18 19 20 21 22 23 10 11 12 13 14 15 16 17 18 19 20 21 Source: Factset, MWM Research, February 2021 Source: Factset, MWM Research, March 2021

• Expansionary fiscal policy & regulatory tweaks: Reporting season results exceed expectations Ongoing housing initiatives such as First Homeowner and low interest rates have had a Following a challenging 2020, banks’ 1Q21 positive impact on housing credit growth, while performance exceeded expectations, with Macquarie reducing downside risks to the property market upgrading earnings by ~10-25% - a substantial as deferrals roll off. The planned removal of the amount for what has been an overlooked sector. Responsible Lending Obligations (RLO’s) is a Positive underlying trends that drove the upside, and positive step in freeing up additional credit for will lend further support for further normalization in housing and boosting credit growth even if it earnings include: presents some headwinds in further competition pressures across mortgage lenders. • Healthier capital positions: Capital positions strengthened across the board, as the majors • Improving economic growth: Ongoing monetary improved their common equity tier-1 (CET1) policy support by the RBA, elevated commodity ratios. These material improvements give us prices, pent up consumer demand and confidence of further dividend increases to come. exceptionally strong asset price markets (housing and equities) are strong supports for economic • Low (or negative) impairment charges: Deferrals growth into 2021/22. Fears of a systemic increase have continued to fall, with active mortgage in mortgage delinquencies have dissipated as the deferrals and SME deferrals making up a small economy has reopened. Macquarie is upbeat on portion of total portfolios (~2-3%). Banks have noted that more than 90% of customers exiting

Macquarie Wealth Management | Investment Strategy Team 2

deferrals are able to meet repayments, although tail risk still exists for remaining customers on deferral.

• Better than expected margins: Tightening of deposit rates underpinned margin tailwinds, providing some upside surprise to banks margins, despite a decline in markets income (which was to be expected).

Jason and the Investment Strategy Team

Macquarie Wealth Management | Investment Strategy Team 3

The report was finalised on 9 March 2021.

Recommendation definitions (Macquarie Australia/New Zealand)

Outperform – return >3% in excess of benchmark return

Neutral – return within 3% of benchmark return

Underperform – return >3% below benchmark return

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Macquarie Wealth Management | Investment Strategy Team 4