One clear theme ran through the latest quarterly financial results from Canada’s largest banks: Lenders are setting aside far more money to handle wonky loans, renewing concerns about how ugly this credit cycle will get.
Canadian Imperial Bank of Commerce underscored the problem. For the three months ended July 31, the bank’s provisions for credit losses (PCLs) – an estimate of loans that will not be repaid – surged to $736-million. That’s up $493-million, or 202 per cent, from the same period last year.
The stock sank 3.2 per cent on Thursday after the bank revealed the numbers, suggesting that investors didn’t like what they saw.
CIBC isn’t alone here. Its peers also reported sharply higher PCLs during the earnings season. The total for the Big Six banks rose to $3.5-billion during the quarter, up 130 per cent from the same period last year.
The provisions are subtracted from bank profits, which means that rising PCLs weigh on earnings.
Again, CIBC offers a stark example. Ignore PCLs and the bank delivered a quarterly earnings gain of more than 13 per cent compared with the third quarter of last year. After including PCLs, though, CIBC’s net earnings fell 14 per cent.
Frank Guse, CIBC’s chief risk officer, said that the provisions largely reflect bank models that point to higher debt service costs for consumers and rising unemployment after 18 months of interest hikes by the Bank of Canada.
“Given the macroeconomic uncertainties, that is the prudent approach to take,” Mr. Guse said during a call with analysts.
The estimates offer a sobering reminder that indebted consumers – especially homeowners with large mortgages that are being renewed at higher rates – are financially stressed right now.
Additional rate hikes and a deteriorating economy could add to the gloom now weighing on bank stocks, which have underperformed the S&P/TSX Composite Index by nearly eight percentage points this year (not including dividends).
Still, investors might want to control the urge to flee from the sector. There are some compelling points in favour of holding onto Canadian bank stocks, even as lenders look increasingly vulnerable to shifting financial conditions.
First, provisions for credit losses are rising, but only from abnormally low levels.
Since 2000, the average PCL ratio – which essentially compares the value of troubled loans to the total value of all bank loans – is 0.41 per cent, according to RBC Dominion Securities.
The ratio soared to a high of 0.82 per cent during the financial crisis in 2009; it fell to a low of just 0.03 per cent in 2021, after low interest rates and government financial assistance during the COVID-19 pandemic reduced credit risk and the banks reversed previous provisions.
Now, PCL ratios are rising again – to 0.13 per cent in 2022 and 0.28 per cent in the banks’ fiscal second quarter. In the most recent quarter, the ratio climbed to 0.35 per cent.
The good news is that the ratio remains slightly below the long-term average, which is why bank executives refer to the current rising trend of credit losses as “normalization.”
The bad news, of course, is that there is no clear indication that losses will stop at normal levels – especially if interest rates remain higher for longer, or a recession challenges the ability of unemployed consumers to meet their loan obligations.
But this outlook feeds into a second point in favour of bank stocks: They’re already reflecting economic uncertainty, limiting the downside risk of holding on.
The average bank stock is down 22 per cent since February, 2022. The sector in 2023 is on track to underperform the S&P/TSX Composite for two consecutive years. That sort of losing streak has occurred only three times since 2000, according to Gabriel Dechaine, an analyst at National Bank of Canada.
Valuations also point to a sector that is already reeling from the frayed nerves of investors. CIBC shares trade at just 7.3 times the 2024 profit estimate from RBC Dominion Securities, compared with a historical average price-to-earnings ratio of 9.7.
More broadly, the Big Six trade at a 12 per cent discount to the sector’s historical average, according to Mr. Dechaine.
Investor sentiment, he believes, has emerged as “the ultimate sector catalyst”: As investors renew their interest in the sector, valuations rise and bank stocks tend to perform at their best.
Granted, that’s not happening now. Mortgage refinancing waves are looming over the next couple of years amid high mortgage rates. This backdrop could continue to make bank stocks unpopular with investors.
Does that make the stocks scary? No, it makes them cheap.
David Berman