Mixed Canadian bank earnings shouldn’t overshadow the fact that fundamentals remain supportive for the sector, owing in part to higher short-term interest rates in this country than in most other countries.
Despite the low interest rate environment and the flattening of the Canadian yield curve - which both pose a challenge for banks - Toronto-Dominion Bank posted earnings per share of $1.75 in the second quarter, and Royal Bank of Canada posted earnings of $2.23, both beating expectations.
Canadian Imperial Bank of Commerce and Bank of Nova Scotia, with EPS of $2.97 and $1.70, respectively, both missed earnings expectations. However, Scotiabank’s earnings included loan provisions tied to takeovers, and their credit card and business loan balance growth reflected underlying strength. CIBC, for its part, was affected by weakness in mortgages.
Overall, core domestic lending business reflected ongoing growth, despite challenges in the residential sector.
With the Bank of Canada likely to keep its key policy rate unchanged throughout this year, we should continue to see positive earnings, reinforcing my preference for Canadian bank stocks over most of their international peers.
A key factor behind banks’ solid earnings is the past tightening by the Canadian central bank, which I think was justified by the stability of the economy. This in turn has lifted Canadian short-term rates above those of most developed markets.
The Canadian 2-year benchmark yield, at roughly 1.55 per cent, is ranked highly among major developed economies, with the U.S. topping the list at 2.16 per cent, trailed by Australia at 1.10 per cent, U.K. at 0.64 per cent, Japan at -0.16 per cent and Eurozone at -0.63 per cent.
The BOC Won’t Cut Its Policy Rate
Looking ahead, markets are pricing in a higher chance of a Bank of Canada rate cut than a tightening over the next 12 months. But our team doesn’t share that view and sees no rate cut over the horizon in the absence of any unforeseen shock to economic growth.
To be sure, the Canadian economy continues to face headwinds and financial vulnerabilities: household debt remains high, U.S.-China trade tensions continue to weigh on business sentiment, and oil remains a risk.
The Western Canadian Select spread recently widened again due to excess supply as a result of U.S. refinery maintenance, long-dated oil prices remain lower than spot prices, while current levels are not very profitable for Canadian producers. We expect oil prices to remain range bound.
Canadian Imperial Bank of Commerce ’s weaker mortgage lending performance shows housing-related risks remain for banks, while tighter lending rules are slowing housing activity. However, we anticipate housing prices and activity to grow, albeit at a slower pace than last year, with the risk of a sharp correction remaining contained.
Still, Canada’s strong labour market will support the consumer facing higher interest rates.
Global economy supports Canada’s outlook
On the external front, Canada will continue to benefit from a solid, albeit slowing, U.S. expansion.
Toronto-Dominion Bank’s earnings support this view, as the bank benefited from strong US retail lending activity.
Along with the U.S. leading the global expansion, slowdowns in the Eurozone and China are stabilizing and our indicators suggest there’s a low probability of a global recession.
Another source of external support for Canada’s open economy is the material depreciation of the Canadian dollar over the last 18 months, whose lagged effects will continue to boost stocks, especially for trade-oriented companies and cyclical industries like banks. Any foreign bank earnings will also be higher as a result when repatriated.
This backdrop will deter the Bank of Canada, which is making its interest rate announcement on Wednesday, from cutting rates.
In fact, from a monetary policy tactic standpoint, the central bank will be better served by leaving some leeway to lower rates without going into negative territory should growth slow down in 2020 or later.
Meanwhile, with global growth slowing and the Federal Reserve patient, I don’t expect many central banks, if any, to hike their interest rates this year.
Canadian banks should therefore keep their edge over most of their international peers, supporting a strong case for earnings to continue to grow despite a slower economic expansion.
That being said, higher growth and rate expectations relative to other developed markets should lead to a loonie’s rebound from current levels, justifying a Canadian dollar overweight in our global tactical opportunities and strategic yield mandates.
MD Financial Management Inc. is a subsidiary of Bank of Nova Scotia.
Rachael Moir is a Quantitative Investment Analyst with the Investment Management and Strategy team at MD Financial Management. She is responsible for supporting strategic and tactical asset allocation and alternative investment mandates.