CBA shares hit a record this week. It doesn’t add up

Updated
Updated

Investors have started the new year convinced of a couple of things: that interest rates will fall, and that this is great news for a bunch of blue-chip companies.

The bullishness is particularly clear when you look at Commonwealth Bank, which this week hit its highest share price on record, trading above $113 a share, pushing its market value to about $190 billion.

CBA shares have recently traded at record highs, fuelled by bets of looming interest rate cuts.
CBA shares have recently traded at record highs, fuelled by bets of looming interest rate cuts.Credit: Eamon Gallagher

Shares in CBA’s smaller rivals aren’t performing quite as well, but the trend is puzzling all the same. Does this really seem like a time in the economic cycle when banks – highly sensitive to any worsening in economic conditions – should be trading at record-high valuations?

It gets more curious when you think about what’s been going on in the banks’ underlying businesses.

Aren’t they slugging it out in a profit-shredding mortgage market price war? Weren’t banks also big winners when interest rates were rising, because they passed on increases to borrowers while dragging their feet on savings accounts? How can they have it both ways, making more profits when rates rise, and then winning again when rates fall?

It’s possible to come up with scenarios that answer all these questions and still paint a rosy outlook for the banking giants at the heart of our financial system. But these scenarios require a lot to go the banks’ way.

A more convincing answer, I’d say, is that the recent rally in bank shares may be overdone, and markets have been getting overexcited in the absence of much real new information over summer.

The big four banks make up one-fifth of the ASX 200 and are therefore hard for investors – let alone big superannuation funds – to avoid. The recent exuberance in bank shares is part of a broader rally in the ASX during late 2023, following a more powerful gain in the world’s biggest market, the US.

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The main reason for the rally has been the hope of interest rate cuts this year – including in Australia – because inflation appears to be sliding back towards the target range of central banks. Futures markets have been pricing in roughly two Reserve Bank rate cuts this year, and all big four banks now think the Reserve cash rate is at its peak, after NAB changed its call this week.

The prospect of rate cuts is generally good for sharemarkets, and throughout past cycles of Reserve Bank rate cuts, bank shares have outperformed.

The recent rally in bank shares may be overdone, and markets have been getting over-excited in the absence of much real new information over summer.

Some of this makes sense: a stronger economy that dodges recession should also result in banks losing less money on unpaid loans. If rate cuts help to support the housing market, it is also likely there will be stronger credit growth, which is also good for banks.

Falling bond yields – which go hand in hand with rate cuts – can also make shares with high dividends (such as banks) more attractive.

Banks have also done well in past rate-cutting cycles by “re-pricing” their enormous home loan portfolios. This is market-speak for only passing on some of the Reserve Bank’s reduction in interest rates to borrowers, thereby boosting bank profits.

However, that trick would surely be harder for banks to try this time around. While this tactic of dudding borrowers on rate cuts has been lucrative in the past, doing it after households have endured the highest inflation in 30 years would surely risk a political backlash. More generally, more and more borrowers appear to have figured out these tricks, realising that you need to be open to sometimes switching banks, or at least negotiating your loan, in order to keep your interest rate competitive.

Instead, it looks far more likely that bank earnings are going to fall in the year ahead, as their profit margins continue to decline due to fierce competition.

When NAB, Westpac and ANZ reported their full-year profits in late 2023, the big theme that spooked investors was the sharp decline in net interest margins or NIMs (funding costs compared with what banks charge for loans.) The key reason for this plunge in NIMs has been an outbreak of fierce competition, as banks try to lure customers from rivals with cheaper rates.

While the intensity of that battle appears to have faded a bit, markets are still convinced NIMs have further to fall. Goldman Sachs analysts this week forecast a further 9 basis point contraction in the major banks’ NIMs this year, pointing to ongoing competition and high funding costs.

The market is also convinced that bank profits have probably peaked, even if we are more likely to get an economic soft landing. Given that, Citi analyst Brendan Sproules last week said the recent run in bank share prices was “difficult to justify, in light of increasingly full valuations and deteriorating fundamentals”.

Morgan Stanley analyst Richard Wiles also this week explored the recent share price surge, saying markets appeared to be betting on a brighter outlook for the economy and bank profits over the next two years. He argued that for this to occur, there would need to be a stronger mortgage and housing market; a dampening in mortgage rate discounting; some meaningful “repricing” of mortgages; and further growth in bank dividends and share buybacks. That sounds like a lot to me.

The sharemarket appears to be pricing in a dream scenario for banks, when the outlook for the economy and the banking industry is still highly uncertain.

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Source: Thanks smh.com