Barclays Capital is initiating its coverage of the Canadian banks with a neutral rating, arguing that valuations are outstripping reasonable growth expectations.

In a report release Monday, Barclays Capital says the ‘Big 6’ Canadian banks are in a solid position, given that they have maintained their strong capital levels, and that their underlying domestic economic outlook is similar for them and their global peers.

If anything, their capital levels may be too robust, the report suggests. “Their over-capitalization is negatively impacting profitability which will inevitably weigh on future valuations,” it says, adding, “We believe allocation of capital will be a key differentiator over the next few years.”

Moreover, it cautions that there are simply too many questions about the earnings outlook to justify the banks’ valuations. “Current valuations reflect an environment of, if not outright steady growth, some degree of predictability and stabilization in revenues. However, we believe a myriad of factors including additional credit deterioration, significant declines in trading revenues to more normalized levels and additional slowing of loan volumes will generate additional earnings pressure in the coming quarters which is not priced into current valuations,” it says.

Barclays maintains a pessimistic outlook for 2010 earnings, forecasting an average decline of 4%, but adds that “there is significant reason for optimism in 2011 as easing pressures, most notably credit, should generate substantial growth.”

“However, given that we believe expectations for earnings in 2010 are overdone and valuations will be choppy for some time, it is likely too early to rely on 2011 for valuation purposes,” it says. “We advocate waiting for an even greater pullback before committing to an overweight stance in anticipation of growth two years hence.”

The report concludes that the banks’ dividends are secure, but they likely won’t be returning capital to shareholders in the near future. “The banks will likely face resistance should they consider raising the dividend in the near term, but we anticipate that most will declare increases by the end of 2011,” it says.

Within the sector, Barclays is overweighting National Bank and TD Bank, “as we believe their valuations reflect strong risk-reward profiles”. Conversely, it is underweight Royal Bank and Bank of Nova Scotia, “as their relatively lofty valuations do not account for any potential revenue declines or additional credit deterioration, in our view.” It is equally weighting Bank of Montreal and CIBC.