The trajectory of interest rates set by the Reserve Bank of Australia (RBA) and its influence on inflation will be pivotal in determining whether Australian bank shares can sustain their high valuations and continue their growth into 2025, analysts have observed.
The Australian financial sub-index (.AXFJ), which is dominated by the nation’s largest lenders, has surged nearly 30% this year, marking its strongest annual performance since 2009. This impressive growth significantly outpaced the broader S&P/ASX 200 index (.AXJO), which rose by a comparatively modest 8%.
This stellar performance has been attributed to robust inflows from superannuation funds and retail investors, who have been drawn to the banks’ reliable capital returns amidst a subdued economic backdrop. Analysts highlighted that steady earnings and high asset quality have further bolstered confidence in the sector, leading to increased fund allocations.
Additionally, optimism around China’s growth and its impact on commodity prices drove a broader revaluation within the materials sector, creating a ripple effect across the Australian financial landscape.
“Given the valuation stretch in the bank sector, any fatigue in flow from what has been the dominant driver this year could be a trigger for multiple derate back to more normal valuation levels,” noted analysts at Morgan Stanley. They suggested that a shift in market sentiment could spark a rotation away from banking stocks towards other sectors such as resources, a key pillar of the Australian economy.
Banking giants lead the charge
The Commonwealth Bank of Australia (CBA.AX), the country’s largest lender, saw an extraordinary 39% surge in its share price this year, becoming the most valuable company on the Australian stock market. CBA shares last traded at A$155.12, significantly exceeding the average 12-month price target of A$104.37, with a forward price-to-earnings ratio of 27.55, according to data from LSEG.
Other major banks also delivered strong performances. National Australia Bank (NAB.AX) climbed nearly 22%, Westpac Banking Corporation (WBC.AX) soared by 42%, and Australia and New Zealand Banking Group (ANZ.AX) logged a gain of approximately 11%.
Interest rates hold the key
Whether this rally in banking stocks continues will largely hinge on the RBA’s monetary policy decisions. The central bank has held interest rates steady at 4.35% throughout 2024 but has indicated a potential shift toward easing as early as February 2025, should economic data align with expectations.
Market participants have already begun pricing in a 50% likelihood of a rate cut in February, with a quarter-point reduction fully anticipated by April.
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A reduction in rates could lead to a reallocation of investments across other sectors on the ASX, as businesses outside of banking stand to benefit from the economic relief provided by lower inflation and borrowing costs. Conversely, if inflation remains stubbornly high and rates stay elevated, Australian banks may face challenges such as deteriorating asset quality and subdued consumer spending, warned analysts at Citi.
A turning point?
The extraordinary gains seen in 2024 have left Australian banks with valuations that some consider overstretched. Should the flow of funds into the sector slow or broader economic pressures emerge, it could signal a shift away from banking stocks.
Morgan Stanley’s model portfolio reflects this cautious outlook, favouring diversification into sectors such as resources, which could offer more attractive opportunities as the economy adapts to evolving monetary conditions.
While the Australian banking sector has enjoyed a banner year, the sustainability of its elevated valuations remains uncertain. The RBA’s decisions on interest rates in the coming months will be a critical determinant of the sector’s fortunes in 2025. Investors and analysts alike will be watching closely as the central bank navigates a complex economic landscape, balancing inflationary pressures with the need to support growth.
For now, Australian banks remain in the spotlight, but a broader market rotation may be on the horizon as economic conditions shift.
