The shock election result at the weekend is very good news for the bank sector. The sector has already reacted with a sharp rise in all the big four banks, as well as Macquarie (ASX:MQG), Bendigo and Adelaide Bank (ASX:BEN) and Bank of Queensland (ASX:BOQ). What we have to ask now is whether this is a sugar hit or a bottom in the sector’s relative and actual performance. I suggest to you that this is not a flash in the pan, this is the bottom of the sector, a longer term pivot point, and whilst the banks are not going to return to their heady days of delivering growth and income, income accompanied by a sentiment improvement will be enough.

And for our retiree investors, that now relieved body of investors who are more interested in income and franking than capital growth, the message is that the odds of a capital gain have also improved and you can once again confidently keep holding the big banks secure in the knowledge that you can fully utilise the franking credits that these companies provide.

Whilst the big fund managers might not be as interested in the income and franking as a retiree, there is absolutely no doubt that as we write, even the big international fund managers who don’t get franking credits but have the banks in their MSCI benchmark, are sitting in their weekly or monthly investment meetings discussing the sector and the almost universal question is not whether to sell into the rise, but the risk in now continuing to be underweight one of the largest sectors in the market as a host of drivers turn positive.

They are imagining a sector that is yielding 9% including franking, that accounts for 25% of the market, that is one of the lowest risk sectors we have, that is well researched, transparent, low volatility, is at the bottom of the earnings downgrade cycle and is in a sentiment hole.

If you could draw a line under the share price performances, if the sector simply stands still, you now have the prospect of a higher return than bonds and hybrids from a sector that is lower risk than the other 75% of the equity market.

Now imagine if the sector came out of its sentiment hole and rose just 10% in the next year. You’d be looking at a 19% return from one of the lowest risk investments in the equity market.

That’s what they are imagining.

The drivers for that possibility include:

  • The removal of political risk. The bank sector was a political football that was victimized by Labor as the “Top End of Town”. Under a Labor government, the persecution of the sector would have been endless. Labor has lost, the Royal Commission has been and gone, the recommendations have been made, the sector has absorbed two years of negative political and public sentiment which, with a Liberal government in place, will end. The persecution is over, and sentiment will lift. A sentiment improvement alone, without any improvement in earnings forecasts, could see the sector recover 10% in the next year.
  • Franking credits retained. Labor seriously misjudged the impact, especially in Queensland, of their policy to abolish the cash refund franking credits. This was an attack on older Australians and a betrayal of people the government should applaud, people who had worked not to be a burden on the state. It was a betrayal of trust that not only showed a disregard for self-funded retirees in the pension phase but for all future retirees - it did not go unnoticed by voters still in the accumulation phase. Our older generation has been in the jungle too long to be treated like monkeys. The upside is that there is now a call for superannuation to be put in the hands of a politically independent body, similar to the RBA, such that it ceases to be a tool of fiscal policy. Wouldn’t that be nice?
  • Income investors can go back to banks. There is a huge crowd of Australian investors who don’t care about the share price – click on the article below. These investors, retirees who are only interested in the income from their investments, are now free to buy the banks again for their franking credits and they started doing that on Monday. What a relief that income investors don’t have to disturb themselves looking for alternative sources of income, setting out on a road to disaster populated by predators. They need do no more than hold the banks once again.
  • Interest rates on the move. The banks will benefit from any move in interest rates. Up or down. It allows them to widen their net interest margin.
  • A lift in the housing market. The bank sector is highly dependent upon a healthy housing market, and for the last two years it hasn’t had it. But, for the reasons below, the odds are that the housing market bottomed last Saturday. If that is the case, then we may also have seen the bottom of the downgrade cycle in bank sector earnings. Imagine how the sector would perform if earnings now bottomed and brokers started upgrading target prices and recommendations instead of relentlessly downgrading them as they have for the last two years.

More on the housing market - Why the housing market bottomed on Saturday:

  • All the activity in the property market that was delayed because of election/political uncertainty can now confidently go ahead. Property listings and clearance rates will now start to rise.
  • Negative gearing will be left alone. Property investors can get on with business, as usual, knowing that the Labor Party are not going to bugger about with negative gearing at the end of the year and, probably, ever.
  • The government’s first home buyers deposit scheme (first home buyers can buy a house with a 5% deposit instead of 20%) is a statement that the government are working to engineer a bottom in the property market. We have both the government and the RBA working to base the housing market. It doesn’t get any better than that.
  • With the election out of the way, the RBA are free to cut interest rates with a 92% chance they will do so next month for the first time in almost three years with another rate cut expected before the end of the year. Brokers are expecting interest rates to be 1.0% by the end of the year with another cut in August. Real estate agents and mortgage brokers rejoice.
  • We have already seen APRA lift lending restrictions in December last year that were imposed in March 2017 - they said in December that those measures were always intended to be temporary - more likely they were intended to be permanent but had become temporary because they caused an unintended drop in the property market.
  • Yesterday APRA also announced that they are now removing the 7% serviceability requirement for mortgage lenders. APRA had told mortgage lenders that they must apply a safety margin to mortgage lending such that a lender must be assessed on their ability to borrow money at 7.0% rather than the current mortgage rate. The banks added another ‘prudential’ 25bp margin to the 7% so before yesterday mortgagees had to prove that they were capable of repaying their loans at a 7.25% interest rate. APRA has told the banks that they now only need to assess a mortgagee’s ability to repay at 6.0%. This brings a whole cohort of new buyers into the market and combined with a 50 basis point interest rate cut the back of the envelope suggestion is that a homebuyer borrowing capacity will have increased by 14% by the end of the year with obvious implications for the housing market.
  • The Liberal win is a boost for consumer confidence as they anticipate tax cuts rather than tax persecution. Consumers are feeling a lot more comfortable since Saturday, as evidenced by a bounce in bricks and mortar retail stocks on Monday. This is also positive for housing market confidence and activity.
  • Less need to downsize. Secure in the knowledge that the Liberal government will not mess with their franking credits, there is less pressure for retirees to sell their homes and downsize.

And…the sector is cheap. Here are the numbers:

And…the sector is back in an uptrend – top of the trading range admittedly (you might wait for a bad day rather than a good day), but back in an uptrend it is.

So a question to the big fund managers. If you are still underweight banks, why?

Read more from Marcus

Marcus Padley is the author of the Marcus Today stock market newsletter. To sign up for a 14-day free trial please click here.

Patrick Fresne

Marcus, could I politely suggest that there is a significant flaw in your line of argument?. The 'case for the banks' outlined above seems to heavily rest on the fact that there will be no tinkering with tax practices such as negative gearing and franking credits following on from the surprise Coalition win on the weekend. The problem here is that -as you yourself have noted in the past- it is poor practice to invest in assets primarily for tax-related reasons. Undoubtedly, more certainty around negative gearing and lower interest rates might help boost the property market, and thus the bank stocks, in the short term. However, tax practices such as negative gearing, or even interest rates fluctuations, are not the most important macro drivers of the property market. The two most fundamental drivers of the Australian property market are demographics and immigration. And here's the rub: during the election campaign, Scott Morrison promised to cap permanent migration at the 160,000 level for four years. It is hard to see how a substantial drop in immigrant numbers could bode well for property prices over the long run. And the demographic situation hardly inspires confidence, with the last of the 'Baby-Boomer' generation reaching the 60 milestone in the next few years, which is likely to result in a glut of properties hitting the market as the Boomers downsize. Those running into the property market and banks stocks might enjoy a short term bounce, but I suspect that in the wash-up many will end up losing their shirts.

Alan Hardcastle

Good points Patrick F. And where will the banks' real growth come from? Sure, have a small percentage of bank shares in the portfolio but longer term they don't look like their going far...

Robert Delforce

Dear so-delusional Marcus - so much further to the right than the far right. To seriously think that a LNP win and lower interest rates will lead to any more than a temporary pause in the housing market decline is pure fantasy [if not delusional in the extreme] and shows a complete lack of conceptual economic knowledge. All the fundamentally flawed LNP first home owner deposit scheme is going to achieve is to place economically naive families at magnified financial vulnerability and risk when the slide resumes and interest rates are normalized again with an aggregate 2.5 to 3% further on down the track...and to effectively be encouraging people to buy of what will likely prove to be still inflated prices is highly reckless. A further 0.5% fall in interest rates is merely a reflection of the LNP-instigated and -managed economic decline also is currently experiencing. Also, please do a google search of "the distortion effects of political intervention in the housing market" [of which the Howard-Costello negative gearing policy was the most notable example of recent fiscal management history] ...and please carefully peruse what that google trolling throws up for you. R. Delforce Canberra Australia - Senior Natural Resource Economist - Retired!!!

Marvin Cathey

Well said Patrick always risky ignoring capital deterioration and focus just on dividends. The economy generally is not looking that flash. Great time to go underweight the banks after such a bounce too

Marvin Cathey

Well said Patrick always risky ignoring capital deterioration and focus just on dividends. The economy generally is not looking that flash. Great time to go underweight the banks after such a bounce too

Matt Christensen

Love 95% of your work Marcus. And appreciate the many many valuable ideas your posts offer. But, if one believes the Banks are.... "(from a sector that is) lower risk than the other 75% of the equity market." (Padley, Livewire), then your decision and mindset to BUY/HOLD Banks is already made. Forget the bear case. Don't read the feedback. You're a buyer, because you've attributed the perceived RISK of the investment too low. Forget the effective ~ 20 x Leverage Factor most Banks carry, and forget the fate of the Banking industry globally (to contracting ROE, and structural pain from lower rates). Or, go back to first principles on RISK, and acknowledge Banks are NOT safer than the other 75% of the Equity market. "One of the best ways to protect your portfolio is to diversify - that is, to spread your investment between different industries. Investing in, say, eight companies in different industry sectors is less risky than just one or two" ASIC website.

Dan J

Looking at CBA's chart it is strangely higher today than it was when the property market started sliding. It is also higher than when the Hayne Royal Commission was called. It's up over 20% in 5 months. Makes me wonder whether the "get long" call may be a little bit late. The housing market may well be due for a bit of respite, but the reality for banks is going to be: -further shrinking of NIMs (increased competition reduces optionality around rate change pass through, deposit rates hit zero lower bound) -ongoing remediation and continued loss of revenue, higher compliance costs post-Hayne (much of this will be recurring, some business practices have permanently changed). -higher impairments (arrears keep trending up) -threat of higher capital requirements from both RBNZ and now APRA. Dividends are further under threat with extremely high payout ratios at present. Though there is some upside risk to the property market near term, its clear that regulators and RBA see downside risk to the economy. That is not a good scenario for banks. Rate cuts greater than 50 bps imply a grim scenario, rising unemployment. Banks will have little choice but to pass rate cuts on and it will hurt their margins in doing so. But better than the alternative which is rising bad debts.

Henry Kaye

Generating retirement income from stocks with 90%+ payout ratios, negative volume growth and record low bad debts - what could go wrong?