Significant Features: The Pendal Property Investment Fund is an actively managed portfolio of primarily Australian listed property securities.

Fund Objective: The Fund aims to provide a return (before fees, costs and taxes) that exceeds the S&P/ASX 300 A-REIT (Sector) (TR) Index over the medium to long term.

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.

Rajinder has over 17 years’ experience in Australian equities and manages our range of sustainability and ethical funds. He is also involved in the development and implementation of our Enhanced and Individually Managed Account strategies. Rajinder holds a Bachelor of Science (Mathematics) and Bachelor of Commerce (Finance) from the University of New South Wales and is a CFA Charterholder.

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. 

Here’s what’s driving Australian equities this week according to Pendal’s head of equities Crispin Murray. Reported by portfolio specialist Chris Adams.

FIVE ISSUES played on the minds of investors last week, leading to a weaker equity market:

• ASX earnings season: Last week’s results were more mixed than the previous week. But it was still a net positive. Management teams continue to indicate that lockdowns are not having as harsh an impact as many feared.
• Domestic Covid situation: A deterioration has led to greater restrictions and more risk to economic growth and earnings.
• Vaccines: New studies suggest vaccine effectiveness in preventing Covid fades relatively quickly, leading to calls for booster shots.
• US Fed: Signalled a more hawkish stance in regard to tapering Quantitative Easing.
• China: Beijing continues to reinforce the notion of “common prosperity,” seen by some as a risk of further market-unfriendly regulation.

The outcome was a 1.94% fall in the S&P300 last week. The S&P 500 was down 0.55%.

It feels like we are approaching a key juncture for equity markets.

The constructive case for equities is based on the view that we are near a nadir of sentiment regarding Delta cases and the sell-off in cyclicals. From here policy supports, signs of peaking cases, resilient economic momentum, earnings growth and liquidity will drive markets higher into year end.

The negative take is that markets are extended on the back of excess liquidity. Coupled with some early warning signals in the data, deteriorating market breadth, more speculative sectors rolling over, growth risks from Covid or inflation and policy tightening it could spell a softer period for equities.

We should have a better read on this by the end of September.

By then we will have a better idea of Delta cases in the US, strength in US employment as benefits roll off and the market’s reaction to tapering by the Fed.

In Australia, resources fell 10.7% last week, driven by lower commodity prices and exacerbated by BHP’s plan to consolidate its Australian and UK listings.

The rest of the market held up reasonably well.

Australia’s Covid situation

The rise in Melbourne cases is concerning. Extended restrictions will mean about 40% of the national economy is now locked down. The acceleration of cases in Melbourne will provide insight on whether lockdowns can achieve Delta variant elimination.

Either way, we are discovering lockdowns now need to be harder and longer to get the desired effects.

The focus on vaccinations is yielding results, particularly in NSW.

The seven-day moving average of daily vaccination rates is now running at 1% of the population and 1.4% for NSW. This is similar to peak rates in Israel and Canada.

In NSW 57% of people have had one dose and 30% two doses.

Assuming current vaccination rates persist, we should hit 70% of the population with one dose by early September and 80% three weeks later.

There is about a five-week lag to achieve the same proportions for two doses.

The debate now is about how far restrictions can be pared back once we reach these levels.

International Covid situation

National case numbers continue rise in the US. But there signs of stabilisation in States that were hit first.

The key question is whether we see evidence of US cases peaking in the next two weeks — as occurred in India and UK. Return to school is a risk to that outcome.

The US hospital system is under some strain. The daily rate in new hospitalisations continues to climb, albeit it at a slowing rate.

A number of southern States are now in a critical position in terms of ICU capacity. This is beginning to affect people’s behaviour and sentiment.

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Crispin Murray,
Head of Equities

Israel’s experience offers an important perspective for Australia. With a high degree of the population vaccinated, new cases were negligible in June. But as soon as they opened the borders — even with strict controls — the Delta strain took hold and new cases surged.

Hospitalisations have also risen dramatically in Israel, although not to the extent of previous waves (despite similar case numbers).

This highlights the challenges Australia faces in the next phase, especially since Delta is already established here.

Vaccine effectiveness

Israeli data continues to suggest that vaccine immunity to Covid wanes at about 20 per cent per month for Pfizer and 7-8% for Astra Zeneca.

Protection against severe infection seems to remains in place, however.

A booster program for over-60s appears to be working. But we don’t know whether the waning immunity issue will persist or if boosters will be necessary for younger people.

The key point is that ongoing management of Covid remains difficult — especially once restrictions are removed and borders are even partially re-opened.

Until we see a Delta-specific vaccine — or we can demonstrate boosters do not wane — we are set to see only limited re-openings, particularly in countries like Australia.

Economics and policy

US sentiment surveys show a marked shift in people’s behaviour in response to the growing Delta wave. Interest in restaurant dining, for example, has fallen 33.5% since July.

The US economy remains strong, however. The Atlanta Fed GDP predictor is still implying 6% annualised growth.

The Fed’s minutes were more hawkish than expected.

Concern over inflation may see Quantitative Easing tapering start in November with an aim of completion by mid-2022 (rather than late 2022). This would provide the Fed with an ability to raise rates by the end of 2022 if inflation warranted it.

There was little in the way of new economic data last week.

Markets

The high degree of uncertainty makes markets hard to call near-term.

The bull case is built on strong economic growth and earnings revisions, coupled with muted expectations. There is some technical support for this case, since the market has pulled back to a trend line that has been a buying opportunity eight times in 2021.

The more cautious view is that the market is not as healthy as it may appear.

Market breadth has deteriorated, though it remains high by historical standards. An equal-weighted version of the S&P 500 — removing the distortive effect of the largest stocks — actually rolled over in May.

There are some early warning signs in credit markets as BB spreads have widened, though this is small.

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We are also seeing the US dollar break higher, weighing on commodities and potentially reflecting some risk aversion.

Bond yields remain low. The question is whether this is the result of central bank buying, or a harbinger of disappointing growth as inflation throttles demand and stimulus effects wear off.

Over the next month we should get a better read on three factors that will guide us on which way the market breaks:

• Whether the US delta wave peaks, boosting consumer confidence
• How the US labour market performs as benefits roll off
• Whether the Fed will prioritise inflation risks or slowing growth

Australian equities

Earnings season is still going well, although there were a few more disappointments than the previous week.

Overall, the proportion of companies beating expectations is running above historical averages, although disappointments are in line.

Resources have performed best in terms of earnings. But similar to February, this hasn’t been reflected in stock moves since commodity price falls have dominated. Financials have so far done better than industrials.

Capital management is positive. About 41% of companies have beaten dividend expectations, versus a 27% historical average. There have been $12.7 billion worth of buy-backs announced, which is supportive for markets.

Earnings downgrades are lower than historical averages, but upgrades are running at average levels.

This reflects falling commodity prices and lockdowns.

About Crispin Murray and Pendal Focus Australian Share Fund

Crispin Murray is Pendal’s Head of Equities. He has more than 27 years of investment experience and leads one of the largest equities teams in Australia. Crispin’s Pendal Focus Australian Share Fund has beaten the benchmark in 12 years of its 16-year history (after fees), across a range of market conditions.

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

Find out more about Pendal Focus Australian Share Fund here.  

Contact a Pendal key account manager here.

Sondal is an investment analyst with over 19 years’ experience covering the Retail, Telecom, Media and Transport sectors. He joined Westpac Investment Management in 1999 and has previously held roles with Commonwealth Bank and Bell Commodities. Sondal holds a Bachelor of Commerce (Finance) and a Bachelor of Science (Maths and Statistics).