Financials now key ASX support

Overnight markets continued to push higher as there was a solid move up in commodities. Some support to equities may be coming from the impressive gains in the oil price.

Source: Bloomberg

WTI oil gained 3.6% overnight as supply disruptions have essentially brought the oil market into balance in May. The oil price has broken out strongly above US$47 and looks to be heading to US$50. But copper has also been gaining (+0.8% overnight) despite weaker Chinese data and a stronger US dollar.

Markets seem to be in a relatively sweet spot with a steadily stronger US dollar and resilient commodities prices. Many investors have been predicting a pullback in markets, but despite all the negativity, markets have continued to grind higher.

The drivers for the ASX appear to be a remarkable resilience in the materials and energy space and a dramatic change in investor sentiment with regards to the banks. Part of this is explained by looking at the forward price-to-earnings premium of different sectors compared to their 10-year average. Financials trade at the lowest premium compared to their ten-year average P/E ratio of any sector, and arguably on valuation terms they have a lot further to run than other sectors.

We will be receiving the release of the RBA minutes today at 11.30 am, and markets will be poring over a more thorough elaboration of their new dovish bias. The likelihood that we see two more rate cuts by the RBA will continue to drive further rallies in the higher yielding banking stocks. The fact that financials are trading at comparatively lower valuation premiums and the strong desire for yield, should drive buying in this heavily weighted sector and that could continue to support the ASX going forward.

Forward earnings-per-share estimates in the ASX are also increasingly looking like they have bottomed. Forward EPS hit -11% year-on-year growth at the start of April, which is almost a full standard deviation below the long-term average. And it is noticeable that when these levels were hit in late-2012, it proved to be the turning point in the earnings cycle.

The Aussie dollar has bounced off the US$0.7240 support level, and future interest rate cuts by the RBA seem to already be priced in. It will be interesting to see if the RBA minutes today will be enough to push the Aussie even lower or whether markets have got ahead of themselves.

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