A Barclays analysis says a weakened economic outlook, low commodity prices and the central bank’s rate cut have contributed to negative sentiment toward Canada’s Big Five banks.Fred Lum/The Globe and Mail
As Canada's economic prospects wane along with the price of oil, a major multinational bank is warning that U.S. investors are likely to place another round of bets against our nation's biggest banks.
"Like all sequels, good or bad, the Great White Short II appears to be inevitable," Barclays analyst John Aiken said.
The last iteration of this trade a couple of years ago was, by all measures, a phenomenal flop. The short positions on the New York Stock Exchange for the Big Five Canadian banks – Royal Bank of Canada, Toronto-Dominion Bank, Bank of Montreal, Bank of Nova Scotia and the Canadian Imperial Bank of Commerce – ramped up in earnest in early 2013, with U.S. investors convinced that the housing market north of the border was due for a severe correction.
But a collapse in real estate values failed to materialize, and Canadian banks continued to post solid earnings growth and increase their quarterly dividends. The S&P/TSX composite banks index surged by nearly 20 per cent in the second half of 2013, meting out punishment to the shorts and prompting them to wind down their bets against the group.
Despite the existence of a government backstop in the form of mortgage insurance provided by the Canada Mortage and Housing Corp., which presumably limits the scope for these institutions to realize losses, Canadian banks continue to be viewed by foreign investors as a proxy for the country's real estate market. Mr. Aiken observed that since 2009, there has been a strong connection between the annual change in the Big Five banks' short positions on the NYSE and the Teranet-National Bank house price index. As the rate of home-price appreciation slowed or trended further into negative territory, U.S. investors rushed to bet against the banks.
This time around, the "short Canada" thesis has some added ammunition.
"Amidst a weakened economic outlook, fuelled by low commodity prices and underscored by the recent Bank of Canada rate cut, we believe the market will see little reason to get excited about the Canadian banks' outlook for lending and earnings growth," Mr. Aiken said. "Consequently, we expect that the 'short Canada' trade will likely resonate for much of the year and could add further negative sentiment to the sector."
While news of shorts can depress sentiment and weigh on valuations, the increased presence of investors betting against a given stock is not a surefire sign that it's time to sell. The example of how Home Capital Group Inc. fared during the Great White Short of 2013 is instructive in this regard. This subprime lender offers mortgages to people who are self-employed, relatively new to the country, or have had a credit incident in the past – segments the big banks generally try to avoid.
The stock was considered to be ground zero for any fallout from a crash in home values, as its borrowers were of a below-average credit quality. Hedge fund manager Steven Eisman, who successfully bet against the United States' housing market prior to the financial crisis, was the biggest name to single out the company's potential woes. Negative sentiment incited a wave of selling early in 2013 that culminated in a frenzied double-digit decline in the first two weeks of May as shorts flocked to the stock.
"If housing rolls over, this company is going to have serious problems," Mr. Eisman said at the Ira Sohn Investment Conference on May 8, 2013 – the same day the company posted quarterly results that beat analysts' expectations on the top and bottom lines. Home Capital continued to record better-than-anticipated growth in 2013, hiking its dividend and announcing a share buyback program along the way. The ensuing "short squeeze," as the case against the lender deteriorated, helped the stock end 2013 more than 60 per cent above its mid-May low.
In addition, it takes a great deal of conviction to bet against the Big Five, which yield an average of 4.2 per cent. Investors who short a stock do so by borrowing it from someone who already owns it and are responsible for paying dividends to the party that lent them the stock before the position is covered.
The extent to which investors have soured on the Canadian banks in recent months is startling, especially when compared with the oil and gas names. Since the OPEC meeting in late November, in which the cartel elected to leave its production quota unchanged, the Canadian energy index has declined by about 1 per cent – but the Canadian bank index has lost one-tenth of its value.
According to Gluskin Sheff + Associates chief economist and strategist David Rosenberg, the selling is nearly overdone and a buying opportunity is on the horizon. "Outside of recessions or that 1997-98 Asian crisis, when the Canadian banks slid 10 per cent in a four-month span, we are either at or very close to a climactic buy," he said.
Disclosure: The author owns shares of TD.