Chinese banks must brace themselves for 4 downside risks

Time to get more defensive.

The launch of Shanghai-Hong Kong stock connect scheme in October is believed to likely be broadly positive for H-share stocks but that any near-term share price strength presents an opportunity to reduce holdings.

According to a rsearch note from Barclays, H-share China bank stocks under our coverage provided a total return of 24% on average from the trough in late-March.

Thus, it believes that most of the positive catalysts – hopes for more macro loosening measures, banks' annual dividend payouts, good results (detailed tables in this report), preference share issuance plans, etc. – have been reflected in this rally.

Here's more from Barclays:

We now turn more defensive as we see more downside risks emerging:

1) more tolerance by the government towards a lower GDP growth;

2) a large stimulus unlikely in 2H14 but targeted easing to continue;

3) worsening of banks' asset quality and resultant slower profit growth with higher credit costs; and

4) China now appears to be in the middle or late stage of the monetary loosening cycle (banks have historically outperformed at the beginning of the cycle).

However, reform plans if successfully implemented should be positive for China banks in the medium to long term, but this would likely be a multi-year gradual development and more beneficial to select banks.

With our now more cautious view, we downgrade ABC, CMB and ICBC to EW from OW. BOC is now our only OW in the China banks space.

A more "neutral" macro stance: Given Premier Li Keqiang's recent speech, we see more tolerance towards a slower domestic economic growth.

We believe that China will maintain the steady monetary policy and that the government is not going to boost the economy by significantly increasing the money supply, which may disappoint the market. It also appears unlikely that the central bank will cut the RRR or interest rates in 2H14.

Asset quality to continue deteriorating, particularly if no strong loosening policies: Under our estimates, the average gross NPL formation rate for banks under our coverage reached 1% in 1H14 (vs. 0.77% in 2013 and 0.69% in 1H13).

We expect that the high gross NPL formation trend will continue in 2H14 and that banks will maintain high levels of write-offs/disposals to stabilize reported NPLs. With credit costs likely to stay high and fee growth to slow, we expect China banks' bottom line growth to further ease in 2H14.

Downgrade ABC, ICBC and CMB to EW; BOC is now our only OW: With our marginally adjusted growth drivers for 2014-16E (lifting credit cost and lowering operating expenses assumptions), we keep our average profit growth forecasts largely unchanged at 9% for 2014, 3% for 2015 and 2% for 2016.

Incorporating our more cautious industry stance and earnings revisions, we lower our price targets by 3% on average. We downgrade the high-beta stocks – ABC and CMB – to EW from OW.

We also downgrade ICBC to EW from OW as we believe its profit growth will slow further and may be the lowest among its large peers. BOC (OW) remains our top pick as we see it as best positioned among peers to benefit from the economic recovery in developed countries and any US interest rate hikes.

Key industry risks: 1) earlier-than-excepted deposit rate liberalization and 2) large NPL spikes if the economy and monetary condition deteriorates more than expected.