Bank of America Merrill Lynch strategist Michael Hartnett advised clients to short Canadian banks and buy U.S. banks with the proceeds as one of his top 15 trade ideas for 2015. For Canadian investors, I can report two things regarding the trade. One, it's working extremely well in large part because of the weakness of the loonie. Two, recent data suggest it might start working even better in the months ahead.
Mr. Hartnett's pessimism on Canadian banks is based on oil prices and the condition of the real estate markets on both sides of the border. He believes, and it's hard to argue, that weaker crude prices will have a larger negative effect on the Canadian economy than in the United States. Also, Canadian bank lending related to real estate will slow while U.S. loans to home buyers and commercial real estate investors will accelerate.
The U.S. Census Bureau released new home sales data Tuesday showing an 11.6-per-cent month-over-month gain in sales, the strongest set of December results since 2007. This was well above economists' expectations of a 2.7-per-cent increase and a clear sign of strength in the U.S. housing market.
At the same time, Bank of Canada Governor Stephen Poloz warned in December that domestic home prices could be as much as 30-per-cent overvalued and poised for a correction.
The two accompanying charts compare the performance of Canadian and U.S. bank stocks. They are identical except in one important respect – adjustment for currency. In the upper chart, a $10,000 investment in the BMO S&P/TSX Equal Weight Banks Index ETF is compared with the same-sized purchase of the PowerShares KBW Bank Portfolio, a U.S. ETF that tracks the widely followed KBW index. This chart does not adjust for changes in the currency.
SOURCE: Scott Barlow/Bloomberg
Since June, 2014, the performance of both investments has been virtually the same if we don't adjust for currency. Look more closely and you'll see that the Canadian bank ETF outperformed by a significant margin until the end of November, and then the performance of U.S. bank stocks outperformed enough to catch up.
The lower chart adjusts for changes in the U.S.-to-Canadian dollar exchange rate and the outperformance of the U.S. bank index is dramatic. In the same time period, American bank stocks outperformed Canadian banks by more than 12 per cent once we account for loonie weakness.
SOURCE: Scott Barlow/Bloomberg
So far, Mr. Hartnett's trade idea has worked well but solely because of currency. But as the effects of the weaker oil price feed through the Canadian economy, particularly in Alberta, where growth has been strong, the more fundamental aspects of Mr. Hartnett's trade idea may increasingly come into play.
Follow Scott Barlow on Twitter @SBarlow_ROB.