Market Insights: Banking on Financials in a Low Interest Rate Environment | BetaShares

Market Insights: Banking on Financials in a Low Interest Rate Environment

BY David Bassanese | 10 May 2016
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The Reserve Bank of Australia’s decision to cut the official cash rate last week – together with growing expectations it will cut interest rates further – has thrown the spotlight back onto yield plays in the Australian equity market.  Although financials have faced bearish investor sentiment in recent months, their still attractive yields and relatively cheap valuations suggest they remain an investment worthy of serious consideration.

Interest Rates Head South

After remaining on hold for exactly one year, the RBA surprised many in the market by cutting official interest rates to a historic low of 1.75% p.a. last Tuesday.  The rate cut came despite still positive signs for the local economy and instead reflected the much lower than expected March quarter consumer price index result, which saw annual underlying inflation drop from around 2% p.a. to 1.5% p.a.

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The RBA acted because it did not see this inflation result as a “rogue” number, as evident by the fact it then substantially revised down its inflation outlook in its May Statement on Monetary Policy released three days after its policy decision.  The RBA now forecasts underlying inflation will hold at 1.5% p.a. until the end of this year, rising to only 2% p.a. by mid-2017.

These inflation forecasts are so low, markets are now pricing in (correctly in my view) at least one – and possibly two – further rate cuts over the coming year.  This is positive news for the economy: with inflation posing little threat at present, the RBA is following its mandate to use its interest rate weapon to ensure the economy grows at its maximum sustainable rate.

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Source:Bloomberg

Declining Rates a Positive for Financials

The Australian financials sector (ex A-REITs) dominates the local equity market, currently accounting for around 35% of the market capitalisation of the S&P/ASX 200 Index.  Although a still popular source of dividend income for many investors, the sector has faced a barrage of negative news flow over the past year  – reflecting capital raisings, higher offshore borrowing costs, and rising bad debt provisions.  Indeed, the S&P/ASX 200 Financials Sector has generally underperformed the market since end-March 2015, declining in price terms by 20.6% to end-April 2016, compared with a decline of 10.8% for the S&P/ASX 200 Index.

That said, as seen in the chart below, the under performance of the sector runs counter to the general tendency of financials to outperform in declining interest rates environments. If this relationship holds into the future, it suggests the RBA’s recent rate cut – together with the prospect of more to come – could lead to improved performance by financials relative to the broader market.

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Supporting the case for financials is the fact that valuations are reasonably attractive – especially if one believes (as I do) that Australia’s property sector is not about to crash any time soon.
As seen in the chart below, the S&P/ASX 200 Financials (ex A-REITs) sector ended April trading at a price-to-forward earnings ratio of 12.1, or slightly below its longer-run average (since 2003) of 12.5.  Given the overall market is currently trading at above-average PE valuations, the financials sector therefore appears relatively cheap, trading at a PE discount to the market of 24% at end-April, compared to a longer-run average (since 2003) of 14%.
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Valuations are even more noteworthy compared to the now very low level of interest rates. According to Bloomberg estimates, as at end-April the grossed-up dividend yield (i.e allowing for franking credits) for the sector was 6.1% p.a. or 4.3% p.a. more than the RBA cash rate of 1.75% p.a.  Due to the decline in financials sector prices, the dividend yield has been rising even as official interest rates have been falling, meaning the dividend yield to cash rate gap has been widening.  On this basis, valuations have never been more attractive in recent decades apart from during the depth of pessimism in the global financial crisis.
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Of course, though questions remain about the sustainability of current bank dividends, even a modest downgrade to dividends would still leave yields relatively attractive in a low interest rate world.

The BetaShares Financials Sector ETF (QFN)

Investors interested in seeking exposure to the financials sector might consider the BetaShares Financials Sector ETF (ASX Code QFN).   QFN aims to track the price and income performance of the S&P/ASX 200 Financial-x-A-REIT Index (before fees and expenses).  The Index comprises the shares of the largest companies involved in the financials sector listed on the Australian Securities Exchange, excluding Real Estate Investment Trusts.
As such, QFN provides a handy way for investors to gain diversified exposure to the financials sector – and thereby reducing the stock specific risk associated with exposure to any one company – all within a single investment.
Based on the closing value of the Fund as at end-April, QFN had a trailing 12-month net yield of ~5.0% p.a. and a grossed up dividend yield of 7.2% p.a*.
*Yield figures calculated by summing the prior 12 month net and gross per unit distributions divided by the fund closing NAV per unit. Past performance is not an indicator of future performance

2 Comments

  1. PAUL  |  May 11, 2016

    You don’t seem to ever mention your HVST as a creditable investment in the current market.

    Are they still relevant, or are there more attractive options?

    1. Jeremy Benson  |  May 30, 2018

      Hi Paul,

      Thanks for your enquiry and apologies for the delayed response. Unfortunately we can’t provide you specific financial advice, so you must judge for yourself whether your investment rationale for HVST still stands.

      If you’d like more information on all 45 of our funds, including our other equity income funds, the full list can be found here: https://www.betashares.com.au/fund-list/fund-overview/

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