Trend Turning for the Banks

Trend Turning for the Banks

Just a few more days and this depressing thing they call the US presidential election will be over.

Maybe my memory just isn’t very good, but when was the last time the US had an election that was as depressing as this? It’s a case of ‘better the devil you know’, or perhaps ‘the lesser of two evils’.

What a sad, sad state of affairs.

In a boost for Hillary Clinton two days out from the election, FBI Chief James Comey said that the Bureau won’t be taking any action in relation to her use of a private email server as Secretary of State.

Who knows what level of backroom dealing or political pressure led to that decision?

The Clinton campaign was clearly rattled by the FBI investigation. Trump, the misogynistic bully, gained momentum at the crucial moment. Maybe that momentum will be arrested at the crucial moment.

For clues on how things are unfolding, look no further than Mexico. The US’ southern neighbour is literally on the frontline of this election. Trump, if elected, wants to build a wall between the two countries and attack free trade. (Quite the Republican, huh?)

For this reason, Mexico will suffer heavily from a Trump victory. And financial markets know it. The Financial Times reports that investors have bet heavily against Mexico as the election reaches its final stages.

Investors have placed bets worth around $745m that Mexico’s stock market will fall in the closing days of the US presidential race as opinion polls suggest Democratic candidate Hillary Clinton’s lead over Donald Trump, the Republican candidate, has narrowed.

The bets against the Mexican stock market have come via BlackRock’s $1bn Mexico exchange traded fund. Approximately three-quarters of the ETF’s assets are being shorted, suggesting some investors are preparing for a Trump win.

Around 80 per cent of Mexico’s exports go to the US. The Latin American economy is expected to suffer if Mr Trump wins the White House, due to his protectionist trade and immigration policies.

Jim Rickards has a much simpler ‘Trump Trade’. Go here to learn more.

Financial markets seem much more concerned about a Trump victory than they were a month ago. The S&P 500 suffered its ninth consecutive loss on Friday. The Financial Times says this is the worst losing streak since December 1980.

That’s quite a feat. What’s even more remarkable, though, is that the S&P 500 hasn’t actually fallen that much. Each day has represented only a slight fall, with the nine down sessions equating to a loss of only around 3%. There have been no panic selloffs.

As I pointed out last week, though, both the S&P 500 and the Dow Jones Index fell through important support levels. If Trump wins the White House, I’d expect to see the falls gather pace. But if Clinton gets up, you’ll see a decent rally.

That’s especially the case because, in the past few weeks, investors have clearly positioned for a Trump win. That is, they have hedged (protected) their portfolios by buying gold, selling Mexico, and moving to cash.

So if Clinton does get up, you’ll see this unwind quickly, and we could be in for a decent rally.

Even if that is the case, however, any upside is likely to be capped in the short term by the expectation of a Federal Reserve rate rise in December.

US employment data for October, out last Friday, came in a little below expectations, but September’s data received a 35,000 positive revision, with the overall unemployment rate falling from 5% to 4.9%.

Whether you believe these numbers or not doesn’t matter. ‘The market’ takes it at face value (as does the Fed), and it increases the chances of a December rate rise. Only a Trump victory on Tuesday would bring it into question now.

Meanwhile, back in Australia, it is bank earnings season again. Today, Westpac [ASX:WBC] reported a full-year cash profit of $7.8 billion, which represented a flat result on last year, but was within expectations.

The key take-away, though, is that WBC is less profitable than it was last year. Its return on equity (a key measure of profitability) fell nearly 200 basis points, to 14%.

That’s still a pretty good return for a bank. Consider that most North American and European banks generate a return on equity closer to 10%. If the economy remains weak and bad debts continue to creep higher, that’s the direction our banking sector is headed.

It might take a few years to get there, but the trend is not friendly. While the lure of high dividends will keep investors faithful to the big banks, the erosion of profitability should ensure share price growth remains elusive.

It may even be a case of flat returns for years to come. That is, any dividend benefit is offset by capital losses. In other words, the banking sector remains an uninspiring place to invest.

The headlines are positive. After all, banks make ‘X’ billions of dollars each year, right? But a share price doesn’t respond to what a bank makes now. It responds to what it will make in the future, and to how much capital it needs to produce that return.

In other words, a share price is a function of how profitable a business is. And bank profitability has been falling for a few years now.

That’s why bank share prices peaked in early 2015. In Westpac’s case (see chart below), the share price peaked at $40. It closed on Friday at just under $30.

Source: BigCharts
[Click to enlarge]

That’s a capital loss of 25%, which is about twice as much as two years’ worth of dividend payments.

As you can see in the chart, Westpac’s share price has gone nowhere this year. With a declining return on equity, it’s hard to see how this trend will change anytime soon.


Greg Canavan,
For Markets and Money

Greg Canavan

Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing.

He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’.

Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors.

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