Why banks will battle to extend the recent rally in their stocks

Two global brokers have taken the lens to the major bank stocks – and the outlook is challenging.

The global end-of-year rally that finished 2023 came just in time for Australian bank stocks.

The perfect illustration comes from shares in Commonwealth Bank, the local sector leader, surging to a new all-time intraday high of $114 this week.

Moreover, in contrast to shares in BHP, Rio Tinto and others, the banks have remained remarkably resilient in January.

Analysts are yet to resume their pre-Christmas research output, but already two major brokerages locally have informed their clientele it’s probably best not to have too high expectations regarding the performance of bank shares in 2024.

It’s about sector valuations, for sure, but more so about operational challenges and headwinds. These were largely ignored when money was flowing in because, you know, the sun was shining and everybody seemed optimistic and happy.

First up, banks are expected to see profits retreat in the year ahead, probably by some 5 per cent on average, which means there won’t be much potential to increase dividends. Leaving dividends stable will, all else remaining equal, lift the payout ratio. There’s no scenario of grave economic recession baked into such forecasts.

Neither of the two brokers who have done a deep dive on bank stocks – Citi and Morgan Stanley – are forecasting a deep recession, but both identify multiple headwinds that will keep a lid on how well banks can perform operationally this year. Both teams of banking sector analysts have started the fresh calendar year with a negative stance on the sector.

Two scenarios

The team at Morgan Stanley sees two plausible scenarios for Australian banks in the year ahead, summarised as “soft landing” and “bumpy landing”.

The first scenario sees average EPS across the sector falling by 5 per cent in FY24, but allows for a swift recovery in FY25 by some 9 per cent. This scenario equally keeps the door open for new share buybacks and mid-to-high single-digit dividend increases over two years.

Assuming this scenario allows the sector to consolidate around current multiples, Morgan Stanley can see a total investment return (including dividends) of 14 per cent over the next 12 months. National Australia Bank should prove the best performer, with CBA expected to lag.

A more bumpy scenario will see the unwinding of the recent rally and pose more questions about dividends and the recovery in 2025. Morgan Stanley sees potential for average EPS to decline by 11 per cent in FY24, with little prospect of a meaningful bounce in FY25.

The second scenario might see the sector return on average decline by 6 per cent over the next 12 months, with ANZ expected to prove most resilient, and CBA the most vulnerable.

Needless to say, Morgan Stanley is less optimistic about the domestic economy, expecting sector competition to heat up, and trading multiples to fall in response to less favourable outcomes at the operational level.

Up against it

Citi’s assessment acknowledges there are still positives on the horizon. Asset valuations, for instance, are likely to prove more resilient than market consensus is prepared for. But valuations overall are seen as a “problem” in the wake of that strong rally last year, with the analysts’ focus firmly on the withdrawal of liquidity this year.

Australian banks still need to pay back some $100bn to the RBA (for the temporary facility the central bank put in place to during Covid in 2020). This should in itself not pose a major problem, but it will take liquidity out of the local economy.

Citi sees further compression in retail banking, limited repricing opportunity in business banking and falling asset prices.

However, Citi expects, ultimately, the deterioration in operational dynamics will catch investors’ eyes, and it will lead to lower sector valuations, irrespective of a “soft landing” and positive news from a more benign impact from asset devaluation.

Beyond the big four – ANZ, CBA, NAB and Westpac – Citi’s update saw the broker downgrade ratings for regional lenders Bank of Queensland and Bendigo and Adelaide Bank to sell.

Among the majors, both NAB and CBA are rated sell. ANZ and Westpac don’t score higher than a neutral rating.

Over at Morgan Stanley, ANZ is the only major with an overweight rating (the shares are still below consensus price target, but not by much) with NAB on equal weight and both CBA and Westpac rated as underweight.

In both cases valuations/price targets have been reduced across the board. Thanks to that rally at the end of last year, in all cases share prices have exceeded consensus price targets.

CBA and Bendigo are scheduled to report interim financials in February.

The other banks reported in October-November and price targets are consequently relatively “fresh”. Once upon a time, bank share prices universally trading above price targets served as a signal of investor exuberance, not simply for the sector generally, but for the sharemarket as a whole.

As a matter of fact, for many years I personally used this sector indicator as a relatively reliable signal for a pending market pullback. At the beginning of 2024, it’s now simply an additional dilemma for investors.

Rudi Filapek-Vandyck is editor at the investment service FN Arena