MONTHLY MARKET MUSINGS

November 2023

Making A Case For The Canadian Banks 

The economic sensitivity of the "Big 5" Canadian banks[1] has resulted in them experiencing a more difficult environment over the past few quarters, as the market began to price in the expected slowdown in the economy. Higher rates are generally a net positive for the banks as net interest income, which is essentially the difference between interest received from loans versus the amount paid out on deposits, increases. This results in higher net interest margins (NIMs), which represents a bank's net interest income as a percent of its average earning assets, and is viewed as a measure of profitability and growth in the banking industry. As the hiking cycle inches towards its end, bank NIMs have reached their peak and will stabilize and begin to contract from those highs as interest rates level off and eventually come back down. Additionally, the focus for the banks has shifted towards the more challenging economic environment ahead and the fallout from those rate hikes, such as slowing loan growth, expense management and more provisions for credit losses. Loan growth has already started to slow down and more provisions for credit losses have been set aside as credit losses have normalized back to pre-pandemic levels. Losses are expected to increase as the higher borrowing costs begins to affect businesses and consumers forcing them to adapt, which will inevitably result in some defaulting. For the banks, being well-capitalized remains very important as it is a requirement for regulators as well as investors. When a bank has higher capital ratios it generally should have more flexibility, and this is crucial in an environment where capital requirements are increasing. Much of what is mentioned above has been expected for some time and the market has, arguably at this point, priced a slightly worse scenario than a soft landing into the bank shares given the pressure in recent weeks. Over the past few quarters, we have also seen downward revisions to the bank's earnings estimates.

In the near term, the environment for the Canadian banks from a price appreciation standpoint will be very modest given the above-mentioned challenges they are facing, the long-term prospects, however, look quite good. Currently, the dividend yields for the banks are very attractive and they are undeniably safe, even in our worst-case economic scenario. In fact, the last time a "Big 5" Canadian bank cut its dividend was during World War II; not even during the Financial Crisis or the Covid pandemic were dividends lowered[2]. One of the key reasons that the Canadian bank dividends have been so consistent over time is that they are very important holdings for the large Federal and Provincial pension funds and are relied upon to provide dividend income to pensioners throughout Canada. The payout ratios for the Canadian banks also remain very reasonable and in most situations the banks would be more inclined to issue more equity, if needed, to maintain the dividends rather than lower them. Furthermore, given the pressure we have seen on the share prices over the past few quarters, the banks are also now trading at attractive valuations relative to their recent historical levels.

This is not to say that some further downside in the near term is out of the realm of possibility. If the economic slowdown is more pronounced than expected, the general expectation seems to be that the downside in share price would likely be limited to somewhere around 10% or so, if we were to experience a somewhat hard landing scenario, and potentially less than that (0%-10% downside) if we experienced a higher-for-longer scenario where rates remain around the current higher levels beyond 2024. Overall, barring a significantly deteriorating economic environment such as a severe recession, the positive from the higher dividend yields and the attractive valuations should generally offset the near-term risks from those other potential scenarios when the longer term is considered.

The negative amortization on residential mortgages has been another often-discussed topic, and the banks have been actively working with clients on this issue. When a borrower's variable-rate mortgage payments no longer covers the accrued interest, the bank provides several options: lump sum payments, increase the payments, switching to a fixed-rate product, etc. According to the most recent quarterly conference calls, it was noted that many customers are reaching out themselves to get ahead of this issue. Overall, when the loan is up for renewal, the borrowers (if they haven’t already) are required to revert back to the original amortization unless they remortgage altogether or refinance. It is also worth considering that many of these mortgages have probably built-up some equity, and if needed, the borrowers could sell the property at a profit to someone who meets the ratio requirements at the current levels of interest. The Canadian banking regulators have also decided to adopt new capital requirements for residential mortgages to reduce the risks associated with negative amortizations[3]. Analysts have noted that, in general, it is likely to have minimal impact on capital ratios for the banks and that the banks remain very well-capitalized. Mortgages that were originated at the housing market's peak prices in 2020 and 2021 (those deemed most "at risk") will come due in 2025 and 2026, and while this is something to keep an eye on, there is time for banks and borrowers to proactively take action to alleviate some of this risk and for rates to move back lower.

What Are The Takeaways?

Overall, for most investors, the current situation should be viewed more as an opportunity and the near-term noise should not drive any longer-term investment decisions. For those who have already allocated an adequate weight within their portfolios to the banks, maintain your position. For those who are underweight on the banks, adding to your bank holdings is a sensible long-term option at the current attractive valuations. As it stands, all of the "Big 5" banks are yielding above 4.90% and two are even yielding over 7%[4]. It is not often that investors get the opportunity to hold companies with well over half a century of consistent dividend payments and stable dividend growth that yield as much as the "Big 5" are currently. Despite the fact that there may continue to be some near-term headwinds for the Canadian banks, the current valuations and dividend yields make for a solid argument in favour of them.

JAY SMITH, CIM, FCSI

Senior Portfolio Manager & Senior Wealth Advisor          
 

BRAD BROWN, MBA, CFA
Portfolio Manager & Associate Investment Advisor