Bank stocks have rallied over the last 3-4 months.

The recent bank stock rally looks overdone. Valuation multiples have risen significantly, and are now stretched relative to historical norms. Current valuations are disconnected from fundamentals, given the tepid (+2%) earnings growth expected over the next 2 years.

The recent rerating appears to be predicated on the market's anticipation of upward revisions to earnings estimates over the next 12-24 months. However, our analysis of historical trends and current consensus estimates suggests limited upside to forward earnings, even with the possibility of a soft landing and interest rate cuts in the next 12-18 months.

Considering current valuations are above pre-GFC highs and with only modest earnings upside risk, we have reduced our exposure to the banks by reducing our exposure to Westpac (WBC) by 2%. This takes us underweight the stock and even further underweight the sector (Focus Portfolio 13.5% vs ASX 300 21%).

We have increased our allocation to BHP by 2% to a weight of 10%. This reduces our underweight position in the iron ore miners (BHP, RIO, FMG), which currently represent 12.7% of the ASX 300 after a period of YTD underperformance, driven by lower iron ore prices. BHP's underappreciated copper assets keep the stock attractive at these levels.

A key concern on the banks is their elevated valuations, with PE multiples above pre-GFC levels.

While price-to-book ratios indicate less inflated valuations. We note that the returns profiles of the banks have changed significantly over the last 20 years. Over the past 2 decades, the return on equity (ROE) of major banks has declined substantially, largely explaining the decrease in the price-to-book ratios.

Against global peers the Australian banks look expensive. While CBA has a lower ROE (13.3%) relative to JP Morgan (JPM) (14.9%), it trades on a 58% premium on a price-to-book basis. While the historically resilient Australian economy and the concentrated nature of the domestic banking sector deserves a premium, this is excessive. It is a similar story for the other big 4 banks relative to global peers.

What is priced in?

The current valuations suggest the market is expecting earnings upgrades. At the current PE multiple of 16.2x, our estimates suggest the market anticipates earnings upgrades of ~28% for the banks to trade at the 20-year historical average PE (12.7x) and ~14% at 1 standard deviation above the average (14.3x).

CBA's premium valuation, currently trading at a 45% premium to its 20-year average, is a significant contributor to the overall sector premium. However, the elevated valuations extend beyond CBA. NAB, WBC, and ANZ all exhibit pricing disconnects from their historical averages, with premiums of 25%, 16%, and 12% respectively. While the magnitude of the disconnect is less extreme than CBA, it suggests a broader sector-wide phenomenon.

Is the market right?

Historically, when banks have traded at multiples above their 20-year average PE ratio (12.7x) they have unperformed the broader market. On average, such periods have resulted in a subsequent -2.9% relative annual return. This demonstrates the sector’s potential for overvaluation and the historic tendency for there to be a disconnect between market expectations for earnings upgrades and their ultimate realisation.

An analysis of the key levers for potential earnings revisions (credit growth, bad debts, and NIMs) suggests the magnitude of upgrades priced in by the market will be challenging to achieve.

While consensus estimates for system credit growth over the next few years are plausible, the potential for substantial upgrades is relatively limited. According to consensus forecasts, the big 4 banks are poised to deliver solid, albeit ‘trend’, credit growth of ~4-5% p.a. between FY24-FY26. This is broadly in line with our base case expectations.

However, the rally in the banks since late 2023 suggests the market is positioned for further upgrades to credit growth expectations, which has been driven by the rising consensus of a ‘soft landing’ for the domestic economy. Significant upgrades to credit growth expectations are not in our base case, and would likely require a more aggressive than anticipated interest rate easing cycle from the RBA (with futures currently implying 0.635% of cuts by Aug 2025).

The last period of prolonged above-trend credit growth was between FY13-FY15. This occurred amidst a combination of successive RBA rate cuts of ~1.5% (from 3.5% to 2%), strong house price growth, and generally buoyant household and business confidence. Credit growth ultimately slowed after APRA introduced a series of macroprudential policies to prevent excessive credit growth, which included loan growth limits (2014) and interest-only loan restrictions (2017).

A repeat of the strong growth seen in FY13-FY15 is unlikely to be repeated this cycle.

Over the medium-term, more or less ‘trend’ credit growth is likely to be supported by a relatively modest RBA easing cycle and a sound economic backdrop. But we note this is already largely reflected in consensus with limited risk to the upside, in our view, barring a significant shift in the economic environment. Moreover, in recent years APRA has demonstrated its ability to intervene as required to manage credit growth and financial stability, which arguably puts a soft ceiling on credit growth relative to history.

Net interest margins (NIMs) are structurally challenged with mortgage lending competition remaining intense, driving down rates offered to borrowers. This competition is unlikely to falter with Macquarie becoming the fifth new big player. This puts structural pressure on the banks' ability to maintain margins within their core businesses.  

Australian banks are grappling with a two-pronged challenge in the deposit market. Increased competition from new entrants and fintech firms is pressuring them to offer competitive rates to retain their customer base. Furthermore, a mix shift in deposits presents an additional hurdle.

A declining rate environment can challenge margins – this time is likely to be no different

While potential cuts to the official cash rate by the Reserve Bank of Australia (RBA) could lead to slightly less competition for deposits, it's unlikely to be a significant benefit for margins. This is because:

Government/regulatory scrutiny - With high government scrutiny on the banking sector (like we have seen in the supermarkets) amidst the ‘cost of living crisis’, banks will be likely to pass on a significant portion of any rate cuts to borrowers, further squeezing margins.

Rate cuts and NIMs - Historically, lower interest rates have generally led to lower NIMs for Australian banks. Even if competition eases slightly, the overall decrease in interest rates may not be enough to offset the decline in margins.

NIMs pose a downside risk to earnings. Competition remains heightened, while rate cuts can be a headwind for margins, especially with scrutiny from the government/regulator. Margin downside could offset any upside in credit growth.

Across the big 4 banks, asset quality measures have been significantly more benign than the market has expected and credit losses have surprised to the upside as a result, which has supported bank earnings forecasts to date. 

While the banks have so far reported limited signs of stress, helped by a resilient economy, there is little debate that bad and doubtful debt (BDD) expenses will rise from here given both the low base and the still percolating impact of higher interest rates (and dwindling savings buffers) on household balance sheets.

According to consensus forecasts, non-performing loans (NPLs) are set to increase meaningfully over the medium-term to just under 1% of total gross loans on average across the big 4 banks, which is above the 10-year average trend.

A meaningful increase in bad debt expenses is consistent with our base case, although consensus forecasts are still seemingly taking a conservative stance towards asset quality measures for the Big 4, suggesting there is upgrade potential on the bad debts front (i.e. potential for BDDs to be lower than currently expected) with a soft landing.

However, bad debt upgrades alone will not be enough to support this rally. For instance, looking at WBC, the bank with the lowest credit quality of the big 4, even a 50% reduction in its bad debt expense would only drive a relatively modest ~6% increase in its NPAT. This extreme hypothetical scenario is firstly very unlikely, but secondly, it would not reduce WBC’s PE ratio (via a higher ‘E’) enough to make the banks reasonably priced.

While potential improvements in credit growth and a reduction in bad debts offer some upside, the magnitude is unlikely to be sufficient to justify the level of earnings upgrades currently priced into the market. The recent rally appears to be overdone, and achieving the market's lofty expectations is unlikely. This challenge is further compounded by persistent competition within the sector and the ongoing downward pressure on net interest margins (NIMs).