Citing the threat of higher interest rates and likely death of bank merger discussions, National Bank Financial is downgrading the banks to an underweight.

Clément Gignac, the bank’s chief strategist says, says in a new report that it is cutting its rating on the banks for the first time in four years.

The downgrade is based largely on the anticipation of a rising rate environment and the effect this will have on earnings. “Though strong fundamentals (excess capital) and potential dividend increases should limit the downside of bank stock prices, the coming withdrawal of liquidity by G-7 central banks will likely make revenue from capital markets more erratic,” Gignac says, noting that capital market operations account for 20% to 35% of bank revenues.

“If the past is any guide, the upcoming tightening phase could prompt Wall Street analysts to revise down their outlook for U.S. bank earnings over the coming quarters,” Gignac says. “We are concerned that any pullback in U.S. bank stocks could have a domino effect on Canadian banks, given the strong historical correlation. In addition, any decline of housing prices resulting from higher mortgage rates in the hot U.K., U.S. and Australian real estate markets could hurt bank stocks, as investors worldwide become nervous about their positions in banking.”

Gignac also suggests that bank earnings leverage is shrinking as credit quality has improved. “Loan loss provisions have declined nearly $2 billion from their peak of early 2002 — a reduction equal to the increase in pre-tax earnings. With provisions probably near a bottom, earnings will lose leverage in the coming quarters and are likely to return to single-digit growth at best.”

One of the few reasons for holding bank stocks even as these conditions have become clear to most investors over the past couple of months — bank mergers — was probably eliminated with last night’s elections results. “The major reason to hold off underweighting Canadian banks earlier this year was the possibility of P/E expansions associated with industry consolidation,” Gignac says. However, the minority government makes mergers unlikely, he predicts.

“For the first time since early 2000, we are reducing our recommendation on banking stocks to an underweighted position,” Gignac says, noting that the stocks have had a good run. “We feel it is legitimate to do so, since Canadian banks have returned 15% annually over the past four years compared to minus 3% for the S&P/TSX.”