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Canadian bank stocks have made strong gains since the end of October, even as formidable challenges linger over the sector. The rally may be worth pursuing, but stocks are no longer a steal.

Over the past three months, the Big Six banks have moved about 16 per cent higher on average, not including dividends.

After underperforming the S&P/TSX Composite Index through the first 10 months of 2023 by nine percentage points, bank stocks have since moved into the passing lane and have outperformed the benchmark by nearly six percentage points.

The sector is now just 8 per cent below its 52-week high. That marks an impressive comeback after being down as much as 22 per cent in October when high interest rates, a looming recession and concerns about credit quality weighed heavily on bank stocks.

The strength of the recovery has taken some observers by surprise.

“We feel that the market has perhaps become too optimistic even as we acknowledge that the outlook is better than we thought for much of last year,” Meny Grauman, an analyst at Bank of Nova Scotia, said in a note this week.

Since the start of the banks’ fiscal fourth quarter reporting season, at the end of November, valuations have rebounded to 10.6-times estimated 2024 earnings-per-share. That’s close to the historic long-term average, according to Mr. Grauman, and up from a relatively inexpensive price-to-earnings ratio of 9.2 prior to the earnings season.

Using another approach to valuations, the average yield for the Big Six has fallen below 4.9 per cent from 5.7 per cent before the rally.

There’s a short explanation for these rising valuations: Bank stocks – along with many other sectors – are tracking a profound shift in the bond market.

Inflation is subsiding while economic activity in the United States and Canada is holding up. Fears of recession are giving way to a widespread expectation that the Federal Reserve and the Bank of Canada will cut interest rates this year, ushering in lower borrowing costs and removing some of the stress hanging over the housing market.

The yield on the 10-year U.S. Treasury bond offers a clear snapshot of this shift. The yield peaked at about 5 per cent in October, when bank stocks were struggling, but has since retreated below 4 per cent (yields fall as bond prices rise).

Investors betting on more gains for bank stocks can count on interest-rate cuts – as many as five of them, according to financial market expectations – to help fuel the rally, even if the cuts come later than expected.

“The Federal Reserve clearly signaled its next move is likely to be a rate cut, but it is keeping its options open on timing and March may still be too soon,” Tiffany Wilding, an economist at Pacific Investment Management Company LLC, said in a note.

As well, bank dividend yields are still enticing and valuations, though higher, are far from stretched. While bank stocks are nearing their 52-week highs, they are more than 18 per cent below their higher highs in 2022, when interest rates were low. This suggests that the current rally may have some breathing room.

But the year ahead for Canadian banks could be bumpy.

For starters, though observers are far more upbeat about the economic outlook than they were just a few months ago, it is far from clear that the United States will avoid a recession. Gross domestic product is being boosted by fixes to the supply chain, and declining commercial loans in December is a warning sign of weaker economic activity.

In Canada, a coming wave of mortgage renewals is a bigger risk. According to the Bank of Canada, just 45 per cent of mortgages taken out before rate hikes began have been subjected to monthly payment increases. This number will rise to 100 per cent by the end of 2026.

Even if rates are set to decline according to financial market expectations, the median monthly payment for all outstanding mortgages will increase by about 34 per cent by the end of 2027, according to the central bank’s estimates.

Canadian banks expect that homeowners can handle the increases if household incomes hold up. However, mortgage payments are rising as banks are already setting aside more money to cover bad loans, adding another hurdle to growth.

“Profit growth is likely to remain under pressure in 2024 from rising provisions for loan losses and still-high expenses,” S&P Global Ratings said in its 2024 banking outlook released this week.

Canadian bank stocks have enjoyed a strong rebound from a steep selloff. Now comes the hard part.

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