Rudi’s View: Banks, Miners & Quality Small Caps

Rudi's View | Sep 26 2024

By Rudi Filapek-Vandyck, Editor

"The strength of the Australian banking sector is difficult to reconcile with the fundamentals.

"The sector has generated an extraordinary total return of ~50% over the last twelve months, despite a tepid earnings growth outlook and increasingly extreme valuations."

The quote is from Wilsons' latest strategy update released this week but it could have been written at any point during the past nine months or so. Banks have surprised friend and foe. Sector valuations look extreme while market forecasts remain for tepid growth. The phenomenon hasn't been limited to the ASX.

At times, macro forces over-rule conditions on the ground and with the world looking forward to, and preparing for central bank rate cuts, there simply was no stopping the flood of money descending upon the global banking sector.

Meanwhile, resources stocks experienced large outflows as the global economy was clearly slowing, pressured by higher-for-longer interest rates, and ongoing moribund conditions in China.

It created an ever-widening gap between 'expensive' banks and 'cheaply priced' resources stocks. Brokers started initiating upgrades for BHP Group ((BHP)), Rio Tinto ((RIO)) and Fortescue ((FMG)) but it was clear a catalyst was needed.

That catalyst could have arrived this week with China's latest stimulus announcement to put more oomph in its sluggish economy, but price action a few days after the announcement suggests there remains a lot of scepticism among investors when it comes to China and its economic trajectory.

Plenty of expert voices around to tell investors not all resources stocks look undervalued. UBS, for example, maintains iron ore is not a sector to get too excited about. 

Two factors are currently undeniably working in favour of resources:

-Large investors can be underweight banks or resources, but given the index weight each represents locally, they cannot be underweighted both. If there is a catalyst to move out of 'expensive' into 'cheap', as has happened this week, this might well become a self-fulfilling process.

-Traditionally, the November-February period marks a strong performance for China-related commodities. That is only five weeks away.

The above mentioned strategists at Wilsons highlight two additional important points:

-Iron ore miners are equally 'unattractive' from a fundamental point of view (Wilsons' Focus Portfolio is underweight both banks and iron ore miners). Wilsons' preference lays with commodities that have attractive long-term supply versus demand outlooks, such as copper, gold, oil & gas, and lithium.

-The market is relatively 'expensive' in a broader sense with the banks simply priced at the more extreme level (i.e. more expensive among expensive stocks)

Wilsons' Focus Portfolio retains plenty of exposure to healthcare and technology stocks.

Strategists at Morgan Stanley highlight the duration of this week's rotation out of banks into commodities-related exposures is dependent on the direction of commodity prices as well as the market's acceptance of the 'soft landing' narrative. Morgan Stanley's portfolio is Overweight Diversified Miners, gold and energy, with explicit mentioning of uranium.

Earlier in the week, pre-China announcement, JP Morgan had placed everything related to iron ore on a positive outlook, including Deterra Royalties ((DRR)) and Mineral Resources ((MIN)).

UBS, on the other hand, remains bearish on the medium-term outlook for iron ore. This week's sector update on China stimulus and after plenty of questions from the client base, sees UBS highlighting its Buy rating for South32 ((S32)). Both BHP and Rio Tinto remain Neutral rated. Fortescue and Mineral Resources remain on Sell.

On a broader, global view, UBS strategists believe small caps are poised to outperform (with 3X more floating rate debt than large caps), as remains Quality, and to a lesser extent so do growth stocks.