What's behind the bank rally

Talk about winning friends and influencing people.

National Australia Bank chief executive Ross McEwan’s decision to more than double the size of the bank’s share purchase plan (SPP) from $500 million to $1.25 billion will make 150,000 mum and dad shareholders both relieved and happy.

The astonishing rally in banks stocks on Tuesday and Wednesday, which has seen a staggering $31 billion added to the combined value of the big four, means the discounted shares NAB offered in its capital raising now come with a tidy paper profit.

The SPP, which always looked unfairly small when compared with the size of the $3 billion institutional placement NAB completed last month, was priced at just $14.15. But NAB closed at $17.94 on Wednesday, having climbed 7.8 per cent on Wednesday and 14.6 per cent over two days.

That’s a 26.8 per cent gain for those shareholders who got a piece of the bank's SPP – albeit NAB is still trading at its lowest point since the GFC. Happily, though, 98 per cent of retail applicants will get their pro rata allocation under the super-sized offer, meaning they will not suffer any dilution.

The size and speed of the bank rally has been stunning. At the end of Wednesday’s session ANZ closed up 16.2 per cent in two days, while Westpac climbed 15.6 per cent and Commonwealth Bank 9.3 per cent.

But the moves in bank stocks - which helped push the ASX 200 up 3.2 per cent in two days (although it drifted lower late in trade on Wednesday) - speak to a few broader themes driving the Australian market.

The first is the game of catch-up being played by Australian shares. Where Wall Street’s S&P 500 index rallied 32.1 per cent between the end of last week and the most recent low on global markets on March 23, the ASX 200 had only rallied 20.9 per cent.

It’s the banks that held us back. Where the white-hot technology and healthcare sectors account for more than 50 per cent of the US market, the banking sector accounts for 25 per cent of the ASX.

And the banks had become largely disconnected from the rest of the market. On average, NAB, CBA, Westpac and ANZ have risen 8.5 per cent since the March 23 nadir, compared with the broader 20.9 per cent rally.

Matt Haupt, portfolio manager for Wilson Asset Management’s large cap fund WAM Leaders, went overweight banks last week for the first time in the fund’s history, selling out of industrials and materials stocks in what now looks like a well-timed move.

He says the banks had been sold off too hard, with ANZ, Westpac and NAB trading well below the book value of their assets for far too long.

“There was a massive divergence across banks and the rest of the market. It was either the banks would catch up or the rest of the market would sell off,” he told Chanticleer on Wednesday.

What’s surprised Haupt is the sheer volume of buying over the last two days.

Some of it has been short covering, but Haupt says there are also many fund managers who have been underweight the banks for some time and are now wading back into the sector.

“The underweights are still very large, so this could go on for a while,” he says of the surge.

But it’s not just mean reversion driving the banks rally.

Better news about the Australian economy in recent days – including the fact the federal government’s JobKeeper stimulus won’t need to be as large as feared, further measures to restart economic activity in most states, and glimmers of hope in numbers around consumer spending – have sparked some tasty rallies in bedraggled tourism and leisure stocks, retail property trusts and some retailers.

For the banks, better economic news plays to hopes the bad debt cycle won’t be as bad as first feared.

Haupt says the best case scenario would see the large provisions the banks have taken for bad debts in the past month written back as profits.

More relief could come if the Reserve Bank felt confident enough to stop holding three-year bond yields down - that would make lift the yield on the banks’ replicating portfolios. (This is where the banks invest in medium-term bonds to hedge against the prospect of falling rates; the higher bond rates are, the better yield they get, although improvement is very gradual.)

It’s also worth noting the renewed sense of optimism we’re seeing among ASX investors is a global phenomenon, as markets seize on falling infection and mortality rates, the reopening of economies around the world, and hopes for a vaccine.

Global equities now sit just 3 per cent below the levels seen in November 2019, when the virus outbreak was just getting started.

Two neat ways to think of the extraordinary change in investor psychology have been provided by quant legend Dan diBartolomeo, the founder of Northfield Information Services, who revels in solving tricky investor questions and is perhaps most famous for helping to finger Bernie Madoff.

DiBartolomeo has been watching the expected level of the annual volatility of the S&P 500 gyrate wildly over the past six months, from around 12 per cent in November 2019, to a peak of more than 60 per cent on March 13, and back to 40 per cent on April 15. The current level is around 26 per cent.

Using volatility and return expectations (and some maths that’s well over Chanticleer’s head), Northfield has also been estimating US investors’ implied expectations about the length of the pandemic crisis.

In mid-March, as fears about the spread of COVID-19 surged, investors were expecting that the financial world wouldn’t get back to a "new normal" for about seven months, or around the middle of October.

By April, as governments and central banks turned the stimulus tap on full, the implied length of the crisis had fallen to five months, or a finish in mid-September.

Now,the implied length of the crisis is just 26 days, which Northfield says underscores the shift from pessimism.

“Investors are now acting in a way that says things will be back to whatever the new normal is, or at least not having financial markets disrupted, in late June,” diBartolomeo says.

The big question is whether bank valuations – and indeed wider valuations on the local market – might start to look stretched again.

Scott Haslem, economist and chief investment officer at Crestone Wealth Management, sums it up nicely: “The rally is a rational response to the improving economic backdrop. The issue is what price you want to pay for that rationality.”

Haupt says the flood of liquidity provided by central banks is encouraging risk-taking, and pushing up asset prices.

But while it’s always nice for a contrarian strategy to come off, he admits his hopes of sitting on his bank trade are dead in the water.

“The magnitude of the move in the last two days has destroyed the duration of the trade,” he says.

Where ANZ, Westpac and NAB have been trading about 0.8 times book value (CBA is about 1.5 times), this week’s rally takes the trio back very close to book value.

That’s about where they should be, Haupt says. But further gains for bank stocks will likely require evidence that the credit outlook is materially better than expected.

Veteran UBS banking analyst Jonathan Mott, who has been bearish on the banks for some time, did his bit to kick things along on Wednesday when he said the better news on economic growth had made the likelihood of a severe downturn - with bigger credit losses and more dilutive capital raisings - lower.

But like many in the market, he’s worried about the potential for a fresh shock in the final quarter of the year, when the government’s big stimulus ends in October, the banks’ generous loan repayment deferrals are wound back, and the insolvent trading laws come out of suspension. Rock-bottom interest rates will also continue to weigh on the sector’s return on equity.

“Overall, we are more optimistic on the banks near term, however the medium-term challenges for the sector remain," Mott says.