The stock market has rallied nearly 10% in recent months, as investors continued to scramble for yield. The Reserve Bank of Australia appears focused on lowering interest rates and we are expecting two more cuts, bringing the cash rate to 1.75%.

The banking sector
Lower interest rates are continuing to drive investors towards the Australian banking sector, which is over 30% of the capitalisation of the Australian share market. The banking sector is one of the highest yielding sectors, with the big four banks delivering yields of around 4.8% fully franked or almost 7% on a pre-tax basis. We believe Commonwealth Bank of Australia (ASX: CBA) is the best managed bank, but at current prices, the stock looks expensive.

Upside for Macquarie
Macquarie Group Limited (ASX: MQG) is a place within the banking sector offering value, as a number of key factors are helping it. Importantly, it’s clearly in a buoyant earnings upgrade cycle, which means analyst forecasts continue to be exceeded. Under Nicholas Moore, Macquarie is building a consistent track record of under-promising and over-delivering
since the turmoil experienced during the global financial crisis. Macquarie has recently indicated its profit growth is towards 20%, driven by favourable divisional profit trends, currency
and a lower tax rate. A key driver of its strong profit growth is its powerful funds management business, which generates significant management and performance fees. Even after the strong gains this year, Macquarie is trading on a prospective price/earnings multiple of only 14, with scope for superior earnings growth in the next 12 months.
We are confident Macquarie will continue to perform and prove the Australian banking sector can provide value investment opportunities, despite being one of the best performing sectors in recent times.

One bank we are not that keen on is Australia New Zealand Banking Group Limited (ASX: ANZ), which we believe isrunning into some headwinds. In our view, the quality of ANZ’s earnings appear somewhat inferior to other major Australian banks, given ANZ is more reliant on institutional clients and trading activities. Issues in its Asian banking business were also put under the spotlight recently when it released its quarterly update. After a number of years, this strategy still remains questionable.

Firstly, Asia is highly competitive and ANZ’s Asian business is currently less profitable than the rest of its banking business. Secondly, the group’s capital structure creates some problems, because of the joint ventures in Asia. ANZ faces lower returns and more volatility as a result of its reliance on Asian markets, at the expense of its strong core Australian and New Zealand retail franchises. Trade finance in Asia is capital intensive and volatile, which was reflected in the recent softer profit result.

Overall, we believe ANZ lacks momentum and is in need of clear direction. This became clear to us after the departure of senior executive and top job aspirant, Phil Chronican, last week.
Australia’s banking sector remains an important and highly visible component of the economy and many investment portfolios, but its spectacular rise should not persuade investors to ignore the fundamentals of investing.