Canadian bank stocks may fall further

Struggling bank stocks haven’t hit the floor yet because of the threat of recession and the uncertainty around interest rates, analysts say.

The Big Six banks that reported second-quarter financial results last week have all boosted their loan-loss provisions, setting up expectations for more soured loans and dented earnings in the future. Toronto-dominion Bank , Royal Bank of Canada, Bank of Montreal and Bank of Nova Scotia fell short of analysts’ earnings expectations, while Canadian Imperial Bank of Commerce topped expectations.

CIBC, BMO and Scotiabank hiked their dividends while TD announced a massive share buyback program. National Bank of Canada will report on May 31.

Nigel D’souza, an analyst at Veritas Investment Research Corp., said Canadian banks whose operations are primarily focused on Canada — namely, RBC and National Bank — tend to outperform banks focused on international expansion, which include TD, Scotiabank and BMO, in the long term.

“Generally speaking, there are more headwinds for banks and uncertainty in the near term than there are tailwinds,” he said. “Overall, we think we’re closer to the floor for the sector than we are to the ceiling … in terms of their (share) prices.”

One factor that could hurt the banking stocks is the higher funding costs fuelled by high interest rates. Also weighing on valuations are bolstered loan-loss provisions and a macroeconomic environment of high interest rates and inflation, D’souza said.

There are more headwinds for banks and uncertainty in the near term than there are tailwinds

Yet despite recent drops, the banks have outperformed the composite index on a total return basis over the past decade, according to S&P Global Inc. data. The banking group index has returned 9.9 per cent on an annualized basis during that time while the S&P/TSX composite index has returned 7.8 per cent.

John Aiken, an analyst at Barclays PLC, said he remains a “big fan” of holding Canadian banks as a long-term investment and expects dividends to grow alongside earnings, but there are short-term concerns.

“As we are entering into a potential economic slowdown, we are cautious on their nearterm valuations, despite being below historical norms,” Aiken said in an email. “As credit losses begin to accumulate, we are concerned that there will be dual pressures of downward earnings expectations and lower valuation multiples applied to their valuations.”

Investors and economists have sounded the alarm about the possibility of Canada entering a recession as the Bank of Canada tries to bring inflation back to its target of two per cent. But the big banks have yet to show any “material losses,” particularly around mortgage defaults, said Barry Schwartz, chief investment officer at Baskin Financial Services Inc.

“There’s no surprise on the Street about these earnings and … what we’ll have to see is how the next six to 12 months play out in terms of the Canadian economy,” said Schwartz, whose firm and clients hold shares in National Bank, TD and RBC, but maintain an underweight position.

In bolstering loan-loss provisions and hiking dividends, the banks are showing regulators that they are gearing up for a possible recession to protect against future losses, he said. But one upside is that revenue losses and “actual” impairments on loans haven’t materialized yet.

D’souza said he is expecting a moderate recession, which could ultimately impact the banks’ top line.

“Loss provisions will normalize this year, and next year they’ll move materially higher in a recessionary environment,” he said.

The banks have indicated mortgage growth volume could slow, but Aiken said that could have a positive impact on net interest margins since domestic residential mortgages are the banks’ lowest-margin business.

Worries about the banking crisis in the United States also cast a pall heading into last quarter’s earnings season, but he said the pressures in the banking system south of the border “have only had moderate impact” on Canadian banks so far.

“Once there is greater visibility on the economic outlook, we would become much more favourable on the banks,” Aiken said.

Barclays has a neutral rating on all the banks that have reported so far, suggesting their fundamentals are neither improving nor deteriorating. Veritas rates RBC a buy and BMO and CIBC as sells, while ratings on Scotiabank and TD were reduced, indicating they will underperform their peers.