The enduring trend to digitalisation and a faster-than-expected economic recovery are two insights we can learn from strong results among European banks. Paul Wild explains

THE WORD “digitalisation” appears in more and more investor reports and conversations across asset classes and regions — including as a driver of recent European bank results.

Digitalisation refers to the use of technology “to change a business model and provide new revenue and value-producing opportunities” according to researcher Gartner.

It’s distinct from “digitisation”, which simply means converting things such as bank accounts or books from analog to digital.

We’ve noted the digitalisation trend recently in relation to Australian stocks such as Xero and PushPay.

Our emerging markets portfolio managers have also written about its role in driving businesses such as food delivery and online games.

Digitalisation of the economy was underway well before Covid. But the pandemic has accelerated adoption and looks to have raised the benchmark.

The recent run of positive results among European banks is another demonstration of how the trend is helping the bottom line for financials.

People aren’t visiting bank branches liked they used to, often because they can’t. Instead, they’re banking online, and that has big benefits for lenders, who for decades have been trying to reduce their costly branch network.

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As people who bank online know, once you start, you seldom enter a branch.

“We’re seeing decent progress in the banks on the cost side, which has much to do with digitalisation,” says Paul Wild, a senior fund manager who focuses on global equities at Pendal Group’s UK-based business, J O Hambro Capital Management.

“They are going ahead with branch closures, given the Covid crisis has forced customers to move online and into mobile banking.”

European Central Bank data shows that last year the number of bank branches continued to decline across the region by an average of more than 8 per cent. The pandemic helped accelerate the trend. And the lower costs will fall to the bottom line.

Reduced provisioning suggests Europe is recovering quickly

Paul also points out that reduced provisioning among European banks has been a driver of performance this season — which indicates the European economy is recovering quickly.

“The key drivers continue to be much lower provisioning, because the economy has normalised much faster than expected,” Wild says.

“In some instances we are seeing write-backs for generic provisions. Given the economy is where it is, provisioning levels should stay low for the foreseeable future.

There also been much better fee income, he says. “Generally, for European banks fees are about one-third of total revenue and we’ve seen a very strong performance on that front,” Wild says.

Meanwhile, interest rates are starting to rise in Eastern Europe with Scandinavia set to follow.

European bank stocks look good value

Banks in Europe, like some of their peers in other parts of the world, are relatively cheap, says Paul.

“Against a market that is trading at the high end of historic valuations — and a market where again growth stocks have done surprisingly well at a time when bond yields and real interest rates are low but the economic outlook seems to be quite favourable — the banks stick out,” he says.

“At 0.75x tangible book value they are cheap on a historic basis with positive earnings momentum in the sector driving higher returns on equity, complemented by very high shareholder pay-outs to come.”

Investors should also keep an eye on September 30, when the European Central Bank will allow banks to pay dividends again, having asked them to suspend payouts during the COVID-19 crisis.

“We expect to see some very large distributions from European banks, including some very large share buybacks as well,” Wild says.

About Paul Wild and Pendal global equities strategies

Paul Wild is senior fund manager with J O Hambro Capital Management, a London-based active investment manager which is part of Pendal Group.

Pendal offers a range of global equities strategies to Australian investors including:

• Pendal Concentrated Global Share Fund
• Regnan Global Equity Impact Solutions Fund
• Pendal Global Emerging Markets Opportunities Fund

Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management.

Contact a Pendal key account manager here.

Environmental, social and governance factors have come to the fore in the latest ASX reporting season, says Regnan’s Alison George.

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AS THE 2021 full-year earnings season draws to a close, the story of significant profits and dividends — but cautious outlook statements — has been repeated again and again.

Iron ore miners, materials companies, many discretionary stocks and some of the financials have outlined strong performances.

Relatively few companies have failed to meet market expectations. Some four in five companies are reporting profits higher than a year earlier during peak Covid periods.

But behind the headlines another trend gained momentum this earnings season: a greater deference to environmental, social and governance factors among Australia’s biggest ASX-listed companies.

And this is likely to grab more attention in the lead-up to the annual general meeting season in coming months.

“A number of things are spurring companies,” says Alison George, head of research at responsible investing leader Regnan.

“On the social side, Covid and all its implications are being aired. For example there’s discussions about payments that some companies received from the government but didn’t really need.”

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Companies are also focusing on reports from major global bodies about climate change and the transformation needed to address it, George says.

Reporting season ends just two months before the next big global climate change conference — the United Nations Climate Change Conference in Glasgow, Scotland.

“The global gathering has focused companies on their response to climate change, the risks involved and also the opportunities,” George says.

“There’s also been a focus on diversity — and gender diversity in particular. There’s a tie with Covid, because female workers have been hardest hit,” she says.  

“There’s also been more discussion about discrimination against women working on mine sites.”

The latter mostly concerns a state parliamentary inquiry in Western Australia, where major iron ore miners BHP, Rio Tinto and Fortescue Metals have made submissions pointing to the poor treatment of women. BHP outlined alleged cases of sexual assault and harassment, and said it was taking steps to better protect women.

“Fairness and equity in pay arrangements have been a feature of reporting seasons for the past couple of years,” George says. “But it’s manifested this year in issues around broader societal fairness in light of Covid challenges.”

More than most other reporting seasons ESG considerations have come to the fore. And companies that address these issues could benefit in terms of valuations.

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George points to BlueScope Steel, which this earnings season did not simply commit to a long-term net zero emissions goal — it outlined a plan to get there.

“BlueScope makes steel which is a hugely emissions-intensive activity, but is also needed for sustainable development.

“Many companies have net zero emissions aspirations, but BlueScope has backed this with detailed plans and resourcing — both financial and human. That provides investor conviction that the plans are credible.”

As earnings season ends and the annual general meeting season kicks off later in the year, companies that have provided a blueprint for achieving ESG goals will benefit.

“What we want to hear from companies is how they are positioning themselves for ‘future-Australia’, of which carbon transition is a key feature,” George says. “But its also about new technologies, changing consumer preferences and shifting demographics.”

Inflation will rise over the next five years as Australia transitions out of COVID, but investors shouldn’t be alarmed by the prospect of rising prices. Pendal’s Tim Hext explains why 

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FALLING underemployment driving higher wages will be the key driver of inflationary pressures over the next few years as the economy moves back towards capacity.

That’s the view of Pendal portfolio manager Tim Hext, who recently addressed a Pendal on-demand webinar on the outlook for fixed income. 

An underemployed person is as someone who is employed now, but would like additional hours (and is available for more work). 

Importantly, businesses are in a strong position to pass on wage rises as price increases, Hext says.

Unlike previous recessions, many households are exiting the Covid downturn with higher incomes, he says. 

A forecast underemployment rate of 6 per cent in 2023 – alongside an official unemployment rate at 4 per cent or lower – means a full employment economy. This points towards 3 to 4 per cent growth in wages. 

This means services inflation — which accounts for two-thirds of the consumer price index — is expected to rise to 3 to 4 per cent, while goods inflation will likely rise to 1 per cent. 

“And voila, the RBA is hitting their two-and-a-half target,” says Hext. 

“Crucially though, we are still going to have negative real interest rates. Cash rates will be below inflation and bond rates will also be below inflation. 

The implication for investors? 

“Whether you have 2 per cent, 2.5 per cent or 3 per cent inflation — it is low,” says Hext.  

“Provided inflation is seen as low and inflation expectations remain low, it is supportive for risk markets. 

“That’s why I’m alert to inflation but not alarmed.” 

Inflation – a history 

Hext says investors should look at the history of inflation in Australia in three distinct stages to better understand the outlook: pre-global financial crisis, post-GFC and the post-COVID era. 

Pre-GFC, the Reserve Bank of Australia consistently hit its inflation target in a two-decade period characterised by the emergence of China as an economic force, lifting commodity prices and keeping manufactured import prices low. 

After the GFC, Australia entered a second phase when inflation sank below the target. Partly, this was the end of the Chinese-driven mining investment boom and the GFC-inflicted damage to business investment. 

But a more powerful and unheralded driver was strict fiscal policy as governments tried to balance budgets and pay off the GFC debt. 

Hext calls that time the “three 1 per cents”.

“We had inflation 1 per cent below target, we had GDP 1 per cent below capacity and unemployment 1 per cent above full employment.

“And we seemed happy with that. “We were happy to go along in that sludge and fiscal policy was used hardly at all to try and address it.” 

We are entering a third phase

Now, Australia is entering a third phase triggered by the pandemic.  

“It is a huge reset and it is why we are entering stage three of inflation targeting which will last for at least 10 years. 

“We will see inflation a fair bit higher than we have seen in the last 10 years.” 

Hext says the most important reason for this is the return of fiscal dominance where governments are willing to run large deficits in the vicinity of 5 per cent GSP without concerns about high debt. 

“We are actually genuinely striving to run a full capacity economy,” he says. 

Another feature is the move towards a low carbon economy as governments take on the challenge of addressing climate change and start to shoulder the costs of reducing carbon for the long-term benefit of society. 

The transition to a sustainable economy will see shifts in energy sources from oil and gas to green and renewables, lifting costs. 

Alex is responsible for credit research coverage of Infrastructure, Utilities, and Financials.

Before joining the team, Alex spent seven years as a Primary Analyst at S&P Global Ratings, focusing on infrastructure, utilities, and general corporate issuers in Australia and New Zealand.

Prior to his role at S&P, Alex worked for three years as a Senior Analyst in the Audit Division at Deloitte Australia.

He holds a Master of Philosophy in Economic History from the University of Oxford and a Bachelor of Commerce from Monash University.

Alex is also a CFA Charterholder.