KUALA LUMPUR: Hong Leong Investment Bank (HLIB) has downgraded the Malaysian banking sector to "Neutral" from "Overweight", citing weakening earnings momentum, rising asset quality risks and a lack of near-term catalysts to support further re-rating.
HLIB Research analyst Raymond Ng said the current sector valuations have largely priced in optimism surrounding capital management initiatives, with limited scope for further capital reduction beyond CIMB Group Holdings Bhd and Public Bank Bhd.
Ng said the banking sector is entering the second half of 2026 on a softer footing after early-year optimism.
"Early optimism, driven by falling bond yields, attractive dividend prospects and expectations of capital management initiatives, gradually faded amid a lack of stronger catalysts and heightened geopolitical uncertainty.
"The outbreak of the Iran war triggered a broad risk-off sentiment, accelerating foreign fund outflows from Malaysian equities and erasing the sector's earlier gains," he said in a note.
Ng said that while first-quarter calendar year 2026 earnings remained resilient, supported by steady loan growth and stable asset quality, softer non-interest income (NOII) and higher provisions suggest operating conditions are becoming increasingly challenging.
He expects earnings momentum to weaken over the remainder of the year as banks adopt a more defensive lending strategy by prioritising higher-quality corporate loans over riskier small and medium enterprise (SME) financing.
While this should strengthen portfolio resilience, it is also expected to moderate loan growth and dilute lending yields.
"Meanwhile, net interest margins (NIM) are likely to remain under pressure amid persistent deposit competition and the lingering impact of July's overnight policy rate cut.
"Treasury gains are also expected to moderate as bond yields stabilise, while elevated foreign exchange volatility may continue to weigh on banks with sizeable US dollar funding exposure," he added.
Ng said asset quality deterioration and a potential index-related overhang could emerge as the two key headwinds for the banking sector in the second half of this year.
He said statistical analysis indicates that global supply chain disruptions typically lead to a deterioration in gross impaired loan ratios by about 12 months, while rising domestic inflation tends to provide an earlier signal of mounting credit stress.
"Although banks maintain a healthy RM4.1 billion management overlay, a 2.6 times aggregate provision recorded in 2025, sustained cost pressures could still test these buffers if macro conditions deteriorate," he said.
Another potential headwind is the proposed expansion of the FTSE Bursa Malaysia KLCI (FBM KLCI) to 50 constituents, which could temporarily weigh on banking stocks through lower sector weightings in the benchmark index.
Following the sector downgrade, HLIB Research lowered Malayan Banking Bhd (Maybank), Public Bank Bhd, RHB Bank Bhd and Affin Bank Bhd to "Hold" while maintaining "Buy" calls on CIMB Group Holdings Bhd, AmBank Group and Alliance Bank Malaysia Bhd.
It also retained a "Hold" recommendation on Bank Islam Malaysia Bhd on valuation grounds.
Among its preferred names, HLIB Research named Alliance Bank Malaysia as its top pick for the second half of 2026, supported by its resilient earnings outlook and the potential for inclusion in an expanded FBM KLCI.