Slight growth expected for banks as threat from plunging oil weakens

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The sharp decline in the price of crude oil and the uncertainty it unleashed on the Canadian economy weighed on the big banks earlier this year, when share prices stumbled badly.

But as the banks get ready to report their fiscal second-quarter results this week, the threat from oil has largely gone quiet and share prices have begun to recover. Is there smooth sailing ahead?

"The extreme volatility experienced by Canadian bank stocks earlier this year has subsided, in part due to a lessening of the 'all oil, all the time!' concern that pressured the group as crude prices were plunging," said Sumit Malhotra, an analyst at Bank of Nova Scotia, in a note.

"Accordingly, we think the emphasis on the upcoming second quarter reporting season will be on actual bank fundamentals," he said.

If that sounds like a relief, don't expect to be wowed: The fundamentals are pointing to a ho-hum quarter, with analysts expecting overall earnings growth of just 4 per cent over last year.

The big banks are firing on some cylinders, of course.

Capital-markets activity, in particular, is booming. According to Mr. Malhotra, companies listed on the Toronto Stock Exchange raised a total of $21.6-billion in equity financing from February through April, or nearly double the quarterly average seen over the past two years.

That translates into hefty underwriting and advisory fees, which is especially good for banks that have a relatively large exposure to capital markets, such as Royal Bank of Canada, Canadian Imperial Bank of Commerce and National Bank of Canada.

Trading and corporate lending are also performing well, and the banks should benefit from a weaker Canadian dollar, which will boost the value of their U.S. dollar sales and the value of foreign assets.

But the banks also lend to consumers, in a big way – and here, analysts are not seeing encouraging signs of growth.

Oil prices may have stabilized near $60 (U.S.) a barrel, but Alberta's economy is reeling and the Bank of Canada is keeping a cautious outlook on the domestic economy.

While that translates into ongoing low borrowing costs, it also means that already indebted consumers have little incentive to tap banks for additional loans.

The other problem: The banks are struggling with low interest rates and a flat yield curve, undermining their ability to earn money on the spread between their borrowing costs and their lending revenue.

Robert Sedran, an analyst at CIBC World Markets, estimates that this net interest income probably declined by about 1.7 per cent in the second quarter, from the first.

But at least there is little concern about the ability of consumers to pay their debts: "While we expect an impact from elevated loan losses owing to the decline in the oil price at some point, it would appear that any impact will not be felt in the near term," Mr. Sedran said, adding he expects provisions for loan losses to rise just 2 per cent.

Mediocre earnings growth should be a welcome change to investors, who entertained all sorts of gloomy scenarios in the first quarter, when banks performed far worse than the broader market. These scenarios failed to emerge after most banks beat expectations with strong earnings and assured observers that their exposure to the energy sector was relatively low.

The question is whether investors will start to pay more attention to the longer-term outlook for the banks, which some analysts believe is challenging.

"Canadian household debt to disposable income remains at near record highs," said Peter Routledge, an analyst at National Bank Financial. "We conclude that while Canadian households are not stressed at present, high levels of debt do leave them vulnerable to exogenous shocks" that would be damaging to the banks.

The solution, according to John Aiken, an analyst at Barclays Capital, is to focus on banks that are less exposed to these concerns.

"In an environment where domestic retail banking remains challenged, we are more constructive on Bank of Nova Scotia and National Bank, the banks that generate a lower percentage of earnings from domestic retail banking," he said.

Editor's note: A previously published version of this article incorrectly cited a Bank of Nova Scotia analyst report saying that companies listed on the Toronto Stock Exchange raised a total of $21.6-billion in equity financing from March through April. The period in question was from February to April.