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Canadian banks are fairly priced for the slow growth economy but there’s still potential for stock prices to rally when the sector’s earnings season begins Friday, according to Ebrahim Poonawala, bank analyst at B of A Securities.

The belief at B of A Securities is that profit expectations for the domestic banks have been slashed to the point where odds are greater for positive surprises in coming earnings than negative ones, making it likely that stocks will gain over the next couple of weeks.

Royal Bank of Canada (RY) kicks off the season this Friday, with the remaining Big Five banks reporting next week. On average, the Big Five are expected to see average year-over-year profit growth of 2.5 per cent.

The first accompanying chart underscores the drastically reduced earnings outlook for the sector after a 2019 the analyst described as “abysmal” for Canadian banks. The past 12 months have seen analysts carve 9.7 per cent from the 2020 profit estimates of Canadian Imperial Bank of Commerce (CM) and 8.8 per cent from that of Bank of Nova Scotia (BNS). Royal Bank’s forecast has held up best, but has still been cut by 3.6 per cent for 2020 and 1.9 per cent for 2021.

Mr. Poonawala recommends Toronto-Dominion Bank for investors looking for a rebound in the bank sector. As the second chart highlights, B of A estimates that TD will generate the strongest quarterly profit growth at 8.2 per cent.

The analyst also offered numerous other data points putting current bank stock valuations and performance in context, both relative to history and versus the global banking sector.

The big banks are, for instance, trading at a 4-per-cent discount to five-year average forward price-to-earnings ratios and a 5-per-cent discount to historical price-to-book ratios. In comparison with the S&P/TSX Composite Index, the major bank stocks are currently trading at a 33-per-cent discount to the benchmark’s P/E ratio; a 29-per-cent discount has been the average over the past 60 months.

B of A also pointed out that domestic bank stocks have performed roughly in line with their global counterparts so far in 2020. Canadian banks are up 2.7 per cent year-to-date which is better than the 3.5-per-cent loss for U.S. banks and a 4-per-cent drop for Japanese lenders. Domestic bank returns are well behind Nordic bank stocks, which have returned 11.3 per cent so far this year.

Canadian investors were previously accustomed to bank stocks trading at premium valuation levels reflecting their strong and stable earnings growth. Valuations are now lower as profit growth becomes scarce and it appears this “de-rating” phenomenon is a global trend.

The third chart shows that domestic banks, trading at 10.5 times 2020 earnings estimates, are only marginally cheaper than the global average as represented by the MSCI index of global bank stocks. European banks look expensive relative to Canadian lenders, but Mr. Poonawala says that without the anomaly that is Deutsche Bank AG (currently trading at 82 times 2020 earnings), the European banking sector is trading at 9.9 times earnings.

Dividend yields are attractive, no doubt. But if you are looking for earnings growth, these former TSX juggernauts will have to grind it out while steadily increasing provisions for potential losses on loans to indebted households.

Scott Barlow, Globe Investor’s in-house market strategist, writes exclusively for our subscribers at Inside the Market.

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