With the S&P/ASX 200 Financial Sector index getting close to pre-financial crisis highs, there is understandable nervousness over whether valuations in this sector have already been pushed too far. So is it time to get out of Financials? In the main, the answer appears to be no – earnings expectations are holding up well, and valuations are still well below the extremes just before the GFC, especially after considering today’s much lower level of interest rates.
For starters, given persistent downgrades to corporate earnings expectations over the past year – due to falling commodity prices, the high A$, and stubbornly cautious consumer spending – the resilience of Financial sector earnings stands out like a beacon.
According to Thomson Reuters consensus estimates, analysts have been gradually upgrading financial sector earnings expectations for both the current and subsequent financial year through 2014 so far. On current estimates, earnings in FY’16 are expected to grow by 5.6% on FY’15 levels. If these expectations hold up, it would produce growth in forward earnings for the sector by June 2015 of a relatively non-demanding 4.6%. By comparison, in the 12-months to June 2014, Financial sector forward earnings grew by 9.8%.
Valuations at this stage are also far from threatening. While the price-to-forward earnings ratio is above its 10-year average, the price-to-book ratio is very close to its average. On both measures, valuations are considerably lower than in the 2006-2007 period just prior to the GFC.
Compared with this pre-GFC period, moreover, interest rates are now considerably lower. As a result, relative valuations (i.e. earnings and dividend yields compared to bond yields) are close to their 10-year averages, or even still slightly on the cheap side.
Against this, 10-year government bond yields are currently trading around 3.5% p.a. compared with 6.25% p.a. in mid-2007. So the dividend to bond yield gap is currently around +1.5% p.a., compared with a negative gap of 2.25% p.a. in mid-2007 – and a 10-year average positive gap of around 0.6% p.a.
While local banks have probably enjoyed the most of the boost to earnings from reduced GFC related bad debt provisions, they are still enjoying a moderate upswing in credit growth, cheap offshore funding costs, and a technology-driven capacity to cut costs further.
While the Financial sector may struggle to outperform over the coming year – assuming a rising interest rate environment – it still offers non-threatening valuations, and a relatively dependable earnings and dividend outlook for risk-conscious and yield hungry investors.
Investors seeking to express a view on the Financial Sector, may consider looking at our Financials Sector ETF (QFN). The ETF provides simple and transparent exposure to the Australian Financials sector, meaning that with a single trade, investors can get exposure to the entire universe of stocks in the Financials Sector Index. For more information on this product, click here.