File picture: Bloomberg
File picture: Bloomberg

Banks will have their time to shine again

By Opinion Time of article published Jul 27, 2020

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By Ryk de Klerk

JOHANNESBURG - A major sector rotation from top-performing tech stocks to economic cyclicals such as banks could be in the offing in the not-too-distant future.

There is no doubt that investors are having an appalling time because of the dismal performance of the banking sector on the JSE since the recovery of global equity markets after the carnage caused by the outbreak of the coronavirus.

The all share index recovered 97percent of the losses since February 21, while the FTSE/JSE Banks Index is still down by 36percent.

No, it is not a domestic thing only.

The BetaShares Global Banks ETF (BNKS) which tracks the performance of an index that comprises the largest global banks (ex-Australia), hedged into Australian dollars, is down by 22percent in terms of US dollars and compares to a recovery of 96percent of losses by the MSCI All Country World Index in terms of US dollars.

Banks’ severe under-performance is mainly due to sector rotation. China’s rapid flattening of the coronavirus curve and massive economic stimulation by the major economies and economic zones saw a resumption in global trade as supply chains thawed.

This led to what typically happens during the early stages of a global economic upturn cycle.

Commodity prices surged and so did commodity-related equity prices on the prospect of vastly improved profits.

The Covid-19 lockdowns resulted in high unemployment caused by company failures and extreme pressure on consumers’ finances.

The impact of the virus is even far worse than the 2008/09 global financial crisis.

The profit outlook for economic cyclical sectors and specifically consumer-related sectors is extremely weak as they will bear the brunt of lockdowns.

That is in stark contrast with profit growth predictions for growth stocks such as top-performing tech stocks, namely, Facebook, Amazon, Apple, Microsoft, Google and Naspers.

So many true words come from the widely respected Mohamed El-Erian, Allianz’s chief economic adviser, who recently wrote in the Financial Times as quoted on Market Watch: “Rather than buying assets at valuations stunningly decoupled from underlying corporate and economic fundamentals, investors should think a lot more about the recovery value of their assets.”

The profit outlook for South African banks is not encouraging at all. In fact, some banks may even report losses for the 2020/21 year - nobody knows how long lockdowns will continue and how many business failures there will be.

The possible impairments are huge and the banks’ capital adequacy ratios may come under pressure.

The impact of the South African government’s possible interference in the financial sector is unknown.

The one bank may be worse off than the other, who knows?

In the South African context, I see a similarity to what happened during the global financial crisis and now.

The same arguments are being put forward, especially “the business world won’t be the same again”.

Quite frankly, the situation and stage in the global economic and investment cycle is repeated.

Two years from now we are likely to look back and say, “Covid-19: what an opportunity!”

Early indications are that the profits of the FTSE/JSE Banks Index could contract by more than 50percent. That compares to between 17 and 22percent in 1984 and 1985 and 27percent in 2010.

My decision “to invest in or disinvest in bank shares, therefore timing, is primarily based on looking through the cycle” - my quote. The Shiller P/E 10 ratio is a realistic gauge to determine “normalised” earnings. This cyclically adjusted price-to-earnings ratio (Cape) uses average earnings over the past 10 years and smooth out the impact of business cycles.

The average Cape ratio of the FTSE/JSE Banks Index since January 2000 is 14.8 times while the all share index’s ratio is 18.7 times. Banks therefore traded at average Cape discount of 20percent to the market.

In five distinct cases since January 2000, the discount of the JSE Banks Index’s Cape ratio to the JSE all share index exceeded the average of 20percent. My analysis indicates that after the maximum discount was reached the JSE Banks Index outperformed the market over the ensuing two years.

The average excess return above the market was 34percent. The highest excess returns were achieved after reaching a 31percent discount in January 2002, 53percent in June 2008, 28percent in September 2013, and 32percent in May 2016.

The excess capital returns over the ensuing two-year periods following the peak valuation discounts were 43, 58, 25 and 40percent, respectively.

The JSE Banks Index’s current discount to the market based on the Cape ratios is 52 percent.

You will never know when and at what level the maximum discount will be reached - you simply cannot outguess the market. Perhaps we should take our lead from history. In 2002 and 2008, the discounts peaked about one year before year-on-year earnings growth of the JSE Banks Index bottomed.

The index in terms of US dollars narrowly tracked the performance of global bank shares as measured by the BNKS ETF since the end of March this year.

Any major price strength of global banks relative to the MSCI All Country World Index in terms of dollars could trigger similar strength of the JSE Banks Index relative to the JSE all share index and thereby begin to narrow the JSE Banks Index’s valuation discount relative to the JSE all share index.

Yes, banks will shine again and rewards could be high. Patience is of utmost importance though.

Ryk de Klerk is analyst-at-large. Contact [email protected] The views expressed above are his own. You should consult at broker or investment adviser for advice.

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