Banks vulnerable to a bumpy economic landing, Morgan Stanley says
According to analyst Morgan Stanley, the share market's optimism regarding Australian banks may be misplaced following a strong rebound.
The recent surge in bank share prices suggests that investors are overly optimistic about the outlook for the domestic economy, expecting a "soft landing" rather than a potentially more turbulent one, according to a report by The Australian.
“Our analysis points to further upside in a soft landing scenario, but meaningful downside if there’s a bumpy landing,” Morgan Stanley Australia banking sector analyst Richard Wiles told the publication.
Factors influencing market sentiment
The recent change in sentiment towards Australian banks coincided with NAB economists revising their expectation of a final interest rate hike from the Reserve Bank in February. NAB now anticipates rate cuts starting in November, with the cash rate potentially decreasing from the current level of 4.35% to 3.1% by the end of 2025.
All four major banks now believe that the RBA’s next move will be to cut interest rates, The Australian reported.
Market rebound and potential risks
The S&P/ASX 200 banks index experienced a decline of approximately 16% from February to June. This was due to increasing costs, concerns about net interest margins being impacted by intense mortgage competition, and the potential increase in bad debts from the "mortgage cliff" associated with fixed-rate mortgages, The Australian reported.
However, the housing market received support from high levels of immigration, moderated mortgage discounting, share buybacks by banks, and the hope of interest rate cuts and a soft economic landing. As a result, the banks index rebounded by about 18%, with a surge of approximately 13% in the past two months due to expectations of interest rate cuts and improved valuations.
Bank performance and vulnerabilities
In terms of individual banks, NAB and Westpac shares reached their highest levels in almost a year, while ANZ shares tested multi-year highs, according to The Australian. Commonwealth Bank of Australia (CBA) also hit a record high of $114, benefiting from the overall rise in the share market.
However, Morgan Stanley downgraded Westpac's rating to Underweight, leading to a 0.7% decline in its share price. CBA also fell by about 0.6%.
Wiles told The Australian that CBA is the most vulnerable bank in a bumpy-landing scenario, which could impact share buybacks and raise concerns about dividends. On the other hand, ANZ is expected to be the most resilient, and NAB's rating was raised to Equalweight due to its favourable business mix, strong performance, and sound financials.
Valuation and outlook
Morgan Stanley's analysis found that the price-to-earnings valuation of the major banks, led by CBA, has risen even more during this recent episode than it did during previous rate-cutting cycles. The current share price rise largely reflects expectations of multiple rate cuts in 2024 and a more optimistic outlook for the Australian economy and banks' earnings over the next two years.
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Based on estimates, the average price-to-earnings multiple of the major banks is now approximately 15.3 times the consensus forecast of their total earnings per share, The Australian reported. This valuation is higher than both the post-COVID three-year average and the pre-COVID 10-year average, suggesting that share prices already reflect a more positive outlook.
Future outlook
Looking ahead, the performance of bank shares will be influenced by various factors, including domestic inflation and cash rates, competition and margins, credit quality trends, provision releases, and the prospects for new buybacks and ongoing dividend growth, The Australian reported. Morgan Stanley believes that too much optimism is currently priced into the market, leading them to have a negative stance on the major banks.
The outlook for the banks will need to be validated by a stronger housing and mortgage market, less mortgage discounting, meaningful mortgage repricing, further share buybacks, and ongoing dividend growth.
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