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Canadian banks' great run may be nearing end of road Add to ...

Canada's major banks sailed relatively unscathed through the financial crisis, garnering a group reputation as the world's best-run financial institutions.

It isn't surprising then, that investors have grown to love the Canadian bank story. The lenders have great capital levels, consistently high profits, and puny loan losses, all factors to enhance shareholder value.

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But what if this is about as good as it gets, and after a great run, investor caution about these financial institutions is warranted? While this view is not yet widely shared, boutique broker Odlum Brown makes a compelling case for some worry about the sector.

In a recent note to clients, Murray Leith, the Vancouver-based firm's director of investment research, says the banks are facing headwinds, ranging from increasing domestic competition to the possibility of an economic slowdown in China.

While he thinks the Big Six - Bank of Montreal, Bank of Nova Scotia, Canadian Imperial Bank of Commerce, National Bank of Canada, Royal Bank of Canada and Toronto-Dominion Bank - have an average potential upside over the next year of 13 per cent, he cautions that "the risks are biased to the downside at this juncture."

Odlum hasn't slapped an outright "sell" rating on the sector but suggests investors take an underweight position. Odlum reasons that a number of factors are starting to turn against the banks.

There is the problem of high consumer leverage. Household credit market debt is at a new record, at nearly 1.5 times consumer disposable income. Bottom line: Too many consumers are tapped out, which will lead to slower loan growth and more competition for the available business, harming lending profit margins.

Another worry is the expensive Canadian housing market. A turn for the worse in housing, when or if it comes, won't be great for profit growth, either.

Also making Odlum's list of bank-unfriendly trends is the high value of the dollar, which is undermining the country's manufacturing sector, and the possibility that the bull run in the commodity market is undergoing a pause.

"While we do not believe the positive credit environment will change dramatically in the near term, there is not a lot of margin of safety, given that the banks already have a low level of loan-loss reserves," the firm said.

Odlum is nervous about commodities because of moves by China to slow its inflation-prone economy. Any resulting weakness in the Asian powerhouse will hurt Canada's commodity sector and indirectly harm the banks via their customers.

Among the banking group, Odlum says it believes investors' best bet is TD, followed by Scotiabank. "I think they've got a great franchise that they're building in the U.S. that's got lots of growth potential," Mr. Leith says of TD. Scotiabank gets the nod because of its growing international operations.

 
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