Banks look set for a strong quarter, but analysts remain wary

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The operating environment for Canadian banks is looking better. From surging cash levels that will underpin dividend increases, to subsiding credit risks that will allow the banks to release reserves, to rising bond yields that will make loans more profitable, banks look set to reward investors.

But will any of this good news show up in financial results when the Big Six report their fiscal second-quarter earnings starting this week?

Bank of Montreal will kick things off when it reports its financial results on Wednesday, followed on Thursday by Royal Bank of Canada , Toronto-Dominion Bank and Canadian Imperial Bank of Commerce .

National Bank of Canada will report its results on Friday and Bank of Nova Scotia will wind up the reporting season for the Big Six on June 1.

Expectations are high. Bank stocks have rallied to record levels this year, with average gains of 23 per cent year to date. That’s about double the gains for the S&P/TSX Composite Index over the same period.

As well, last quarter’s profits, released in February, exceeded analysts’ estimates by a remarkable average of 26 per cent, raising hopes for another blowout quarter.

Analysts, however, remain cautious.

“As we get set to enter another Canadian bank earnings season, we have to acknowledge that in many respects [the first quarter] will be a tough act to follow,” Meny Grauman, an analyst at Bank of Nova Scotia, said in a note.

He expects that second-quarter operating profits for the Big Six will rise just 2 per cent from the first quarter, weighed down by fewer interest-earning days this quarter and slow loan growth. Some forecasts from other analysts point to a slight decline in quarter-over-quarter earnings.

The year-over-year picture is considerably brighter: On average, analysts estimate that profits will rise about 137 per cent over the second quarter of last year, when banks were building their reserves in anticipation of surging loan defaults.

Now, one of the big questions is what the banks will do with these reserves now that the threat of an economic collapse has faded.

“Credit trends and updated economic forecasts are telling us that the banks are carrying excess performing credit allowances and that delinquencies remain abnormally low,” Paul Holden, an analyst at CIBC World Markets, said in a note.

Does that mean Canadian banks will release reserves similar to the way U.S. banks have done, providing a significant boost to profits?

Robert Wessel, managing partner and co-founder of Hamilton ETFs, recently estimated that the banks will release a total of $6-billion to $8-billion over the next three or four quarters. That offers a boon to profits, but can also drive dividend hikes, share buybacks and acquisitions.

Analysts, though, expect that the release of reserves could take some time. Much of the country is still under lockdown, which means that pandemic-related risks continue to simmer.

And the main banking regulator has not yet given the green light to dividend hikes or buybacks (analysts don’t expect these restrictions to be lifted until September), which means that reserves don’t really have anywhere to go.

While this might look like a downbeat assessment of the coming reporting season, analysts believe there are a number of reasons to stay bullish.

The banks’ wealth-management divisions should do well with rising interest in mutual funds. Capital markets are booming with fees from trading and underwriting. Loan growth is expected to pick up with the recovering economy, as consumers buy more cars and rack up debt on their credit cards – and these loans could be more profitable if interest rates rise.

What’s more, analysts expect that bank stocks can trade at higher valuations, even after this year’s rally has left stocks looking a tad pricey relative to expected profits.

“While valuation multiples are now at a modest premium to trailing five-year averages, we think there are sufficient potential catalysts that the sector can continue to trade well,” Mr. Holden said.

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