Canada’s big banks expected to report modest gains in earnings

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Canadian bank stocks have posted double-digit-percentage gains so far this year, sidestepping threats arising from struggling energy companies, a weak Canadian economy and new rules imposed on the domestic housing market.

But how will banks fare in the coming year?

The country's six largest banks are set to report their fiscal fourth-quarter and year-end financial results starting Tuesday morning. Expectations are modest – analysts forecast profits will nudge just 2-per-cent higher from last year's fourth quarter.

Worries about the banks' loan books from earlier in the year appear to have abated. Oil prices have stabilized between $45 (U.S.) and $50 a barrel, easing concerns in previous quarters that the banks would stand to lose hundreds of millions of dollars in bad loans if energy companies defaulted – with losses potentially spiralling higher if the depressed energy sector spilled into the broader economy.

A modest number of energy companies have defaulted on their obligations and many have sold assets or raised equity in part to pay down debt. Analysts expect the banks will continue to set aside money to cover bad loans, but expect these provisions for credit losses (or PCL) to moderate.

"Notwithstanding a drop in oil prices from current levels, we believe we may have seen the peak in oil and gas PCLs," Darko Mihelic, an analyst at RBC Dominion Securities, said in a note.

At the same time, fears about banks being dragged down by any downturn in the housing market remain largely in check, even as Ottawa has taken steps to tighten regulations around lending. Canadian bank stocks have rallied in recent weeks despite sizable short positions by investors betting the banks will eventually be squeezed.

Some analysts expect the government measures will cool Canada's housing market, which has already seen slower sales in some regions, notably Vancouver. The Toronto area, however, has continued to surge.

One of Ottawa's key proposals is to make lenders share the risks associated with mortgages by introducing a deductible on mortgage insurance. While that would increase the banks' exposure to housing-related losses, some argue there is a benefit for the banks in the long run as they compete against smaller, less-diversified mortgage lenders.

"The creditworthiness of those large financial institutions with more diversified earnings profiles will hold up much better than smaller, monoline mortgage lenders," Peter Routledge, an analyst at National Bank Financial, said in a note.

Recent trends in interest rates have also helped bank stocks. Rising bond yields in the United States and Canada have steepened the yield curve – now that long-term bond yields have risen relative to the yields on short-term bonds – which should make loans more profitable and drive the banks' net interest margins (or NIM) higher.

"Though we have long held that 'seeing will be believing' with respect to NIM expansion for the banks, we certainly acknowledge that the curve steepening seen in the past two months is a positive step in this regard," Sumit Malhotra, an analyst at Bank of Nova Scotia, said in a note.

Mr. Malhotra looked at the reaction of Canadian bank stocks the last time bond yields took off, when the Federal Reserve announced three years ago that it would start winding down its bond-buying stimulus program known as quantitative easing. He found that over the eight-month period between May and December, 2013, when the yields on U.S. and Canadian 10-year bonds surged, bank stocks jumped 17 per cent on the promise of rising profits.

Mr. Malhotra noted that Canadian banks aren't as rate sensitive as, say, Canadian life-insurance companies and U.S. banks, but they clearly benefit.

"As such, the outlook for bank earnings power would improve if bond yields continue to increase," he said.

Still, analysts remain cautious about fourth-quarter results. The economy, after all, is barely growing, consumers are still indebted, and any substantial downturn in housing would hurt profits. But barring any major shocks on these fronts, analysts see gains ahead for the banks' bottom lines.

Some analysts expect profit growth among the big banks will accelerate to as much as 6 per cent in fiscal 2017, as the banks' recent cost-cutting efforts make them more efficient and the headwinds subside. If investors embraced these stocks during a difficult year, a good year should, at the very least, justify the rally in share prices.

Bank of Nova Scotia kicks off the reporting season for the big banks on Tuesday, followed by Royal Bank of Canada on Wednesday, Canadian Imperial Bank of Commerce and Toronto-Dominion Bank on Thursday and National Bank of Canada on Friday. Bank of Montreal concludes the season on Dec. 6.