The weekly wrap: Citi rethink stirs bank rally

The week (ending on Thursday) saw banking stocks taking the lead in a broad-based share market rally that took the S&P/ASX200 Index to a new high for the year. A change in view by bank analysts at Citi on Thursday acted as the catalyst for banking stocks and the share market in general.

It would seem that as economic data continue to improve, and as investors increasingly turn their focus beyond the 2009 and 2010 financial years, the banks are among the main beneficiaries of increased investor confidence that the worst of the global economic downturn is now past us, and the future will bring only better news.

All major banks performed significantly better than the ASX200 Index, advancing between 5.7 per cent to 9.4 per cent against an index gain of 3.1 per cent over the week.

The Australian share market remains caught between the tail end of the global economic downturn - which keeps the gates open for more negative news in the short term- and the prospect of an inevitable bounce from the economic trough, which should translate into much healthier company profits in two years' time. And nowhere is this dichotomy between the short term and the longer term outlook more apparent than in the Australian banking sector.

The difference between stockbrokers and other investment advisors with a positive view on Australian banks and those with a not so positive view on the sector is in essence simply a difference in time-focus. This is probably best illustrated through the earnings projections of what is arguably the most bearish voice on banks among the main stockbrokers in the Australian market; the team of analysts at RBS Australia (formerly known as ABN Amro Australia).

RBS analysts believe the economic downturn in Australia is likely to provide the banks with one last kick in the guts, necessitating higher impairment charges, which will lead to trough earnings for shareholders in fiscal year 2010. This may also cause some banks to further reduce their dividends and even raise some more capital. Beyond fiscal 2010 however, bank profits will be at the forefront of the Australian share market as those nasty impairment provisions will disappear and overall competition in the local market will have been decimated.

Irony has it, those RBS analysts who at present rate three out of the big four Australian banks a sell (with Westpac on hold), are well above most colleagues elsewhere when it comes to earnings per share estimates for the 2011 year.

ANZ Bank, for instance, is projected to endure three consecutive years of EPS decline, but then in FY11 the jump will be no less than 50 per cent, on RBS estimates. As a comparison: current market consensus expects ANZ to achieve EPS growth in the order of 30 per cent in FY11.

No wonder thus that when banking analysts at Citi issued a sector report on Thursday, which in essence suggested impairment charges for FY10 throughout the industry are likely to turn out milder than previously feared, it triggered a good ol' fashioned rally on the stock market.

Despite a negative lead from Wall Street and from commodities overnight, the Australian share market rallied to a new high for the year (4190.40) with the banks in pole position, gaining more than two per cent on average on the day.

Citi analysts did not change one iota of their previous projections for FY11, which are, by the way, higher than those at RBS (the percentage growth is lower because FY10 was never expected to fall to the same extent as projected by RBS). Remarkable is that Citi's revised expectations for FY10 are still below market consensus estimates, but expectations are above consensus for FY11.

Post the Citi sector revision, National Australia Bank and ANZ saw their FY10 EPS upgraded by 12.8 per cent and 13.1 per cent respectively, while Commonwealth Bank and Westpac saw more modest upgrades of nine per cent and 6.3 per cent respectively.

But the real eye-opener, and likely an indication of what might yet follow if Citi analysts have now started a new trend, is the impact of lower impairment charges on the broker's price targets for the big four banks.

Citi's new price target for ANZ of $19.78 compares with $14.50 previously. Commbank's target went up to $45.95 from $35.50, NAB's to $26.12 from $22.50 and Westpac's target has now risen to $24.47 from $19.00. These revised targets compare with present average broker targets of $16.70, $37.44, $23.60 and $20.80 respectively.

The difference between Citi's new price targets and analyst targets elsewhere is that Citi's targets are now above present share prices, even after a strong performance this week, while most price targets elsewhere remain well below bank share prices.

The significant changes in targets were explained in that the reduced threat from impairment provisions will trigger a shift in overall investor perception of the sector. According to Citi, instead of concerns about bank solvencies, investors will now shift from a focus on bank balance sheets toward earnings expectations.

The analysts believe banks are currently hovering around the trough of this economic cycle. The recovery should commence soon and thus Citi analysts advocate now is the appropriate time to shift focus to future earnings, while noting Australian banks are trading close to a 30 per cent discount to their average multiple of the past ten years.