The financials index has been belted over 5% since bank reporting started last week. The market’s correct anticipation of the budget’s bank levy has been a key driver here, and has dominated and somewhat clouded the issue. So to get back to basics, and isolate the single most important theme to emerge from bank reporting – and its investment implications.

ROMANO SALA TENNA, Katana Asset Management

The May 2017 Bank reporting season was largely in line with expectations. Top line earnings were subdued due to constrained credit growth and flat or contracting net interest margins. This was offset by cost discipline, yielding modest earnings per share growth of low to mid-single digits.

Perhaps the most important theme was that capital generation was stronger than anticipated as indicated by the CET1 ratios at or around the ~10% level. This was predominantly due to a reduction in risk-weighted assets. Why is this significant? In effect it strengthens the likelihood that the major banks will be able to maintain their respective dividends at the current levels into the second half of the financial year (subject of course to regulatory changes).

The latest set of results was very much in line with expectations and hence has minimal impact on our current assessment. In short, we see that current bank valuations are at the top end of their historical range in terms of both price to book value and price to earnings, and some way above on a Price to Earnings Growth (PEG) basis. Given the position in both the housing and interest rate cycles, this would normally generate an outright sell.

However, there are 2 factors that mitigate this view:

• The first of these is the likelihood of out-of-cycle rate rises, which will provide a partial earnings buffer.
• The second is the ‘weight of money’. Exchange Traded Funds (ETFs) are growing rapidly and the big 4 banks represent 29.12% of the S&P ASX100 and a staggering 46.55% of the S&P ASX20. As many of the larger ETFs run on these types of indices, it means that close to half of every dollar spent on an Aussie ETF is likely to find its way into one of the four banks. This is an emerging dynamic that can out-weigh valuations and underlying fundamentals.

We nonetheless remain underweight the banks, but are cognisant that these factors could see them trade higher.