Why this top broker thinks you should avoid the Big 4 banks

Morgan Stanley believes Australia's Big 4 banks like Commonwealth Bank of Australia (ASX:CBA) may be poised for a correction.

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On Monday, the Fairfax Press reported that leading investment bank Morgan Stanley believes each of Australia and New Zealand Banking Group (ASX: ANZ), Commonwealth Bank of Australia (ASX: CBA), National Australia Bank Ltd (ASX: NAB) and Westpac Banking Corp (ASX: WBC) are trading in the "sweet spot" but are at risk of breaking lower.

Morgan Stanley's comments stem from analysis conducted by the America-based bank, which suggests that the share price of each of ANZ, CBA, NAB and Westpac implies consensus beating earnings per share (EPS) growth is required for the banks to justify their current prices.

Whilst Morgan Stanley admits the current economic environment makes forecast-beating EPS growth a possibility, I am more pessimistic and believe the big four banks are best avoided for now.

Here's why.

Morgan Stanley analysis

Morgan Stanley argues that the banking sector remains in a "fragile equilibrium" as higher house prices support loan growth. This, however, is being offset by higher household debt levels (as a result of rampant house prices) and weak employment trends.

Further, competitive pressures and new APRA capital buffer requirements are seen to place a strain on margins, which is being balanced by loan repricing and higher commodity prices.

Accordingly, Morgan Stanley predicts a number of challenges remain for the banking sector and that the current forward price-earnings of 12.9x, 14.7x, 13.2x and 14x for each of ANZ, CBA, NAB and Westpac (respectively) does not price in the downside risks.

I tend to agree.

The White Elephant

Australia's big four banks are often touted for their unbridled success as global leaders of safe and reliable dividend yield.

Whilst the current share prices of ANZ, CBA, NAB and Westpac implies a solid fully-franked trailing yield of between 5.05% (CBA) and 6.2% (NAB), investors that have bid up their respective share prices in the chase for yield may be underestimating the risks posed by the elephant in the room – Australia's surging housing sector.

With the 'Big 4' accounting for a whopping 82% of all loans in Australia, it's fair to assume that a fair chunk of their loan books comprise housing debt. Whilst the housing boom has been good to all lenders, including the likes of Macquarie Group Ltd (ASX: MQG), Bendigo and Adelaide Bank Ltd (ASX: BEN) and Bank of Queensland Limited (ASX: BOQ), the recent results of the latter trio show mortgage stress is rising, as bad debts swell at these less-exposesd (to housing debt) lenders.

Although I don't expect a housing market crash anytime soon, I'd imagine the big four are not immune to these industry pressures either and may feel some pain going forward.

Foolish takeaway

As I wrote here last month, Australia's big four banks face a fickle environment of anaemic global growth and deflationary pressures.

To date, the big four banks have performed relatively well in the tightening credit environment. They each continue to post headline growth, but place themselves at risk of exposure to higher household debt (as a result of climbing house prices).

Whilst each of ANZ, CBA, NAB and Westpac provide handy income streams, I'm inclined to sit on the sidelines and wait for a pull-back before buying more bank shares, given their large exposure to Australia's housing market.

Accordingly, I rate each stock a hold at current prices.

Motley Fool contributor Rachit Dudhwala owns shares of National Australia Bank Limited and Westpac Banking. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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