The slowing economy is making it more difficult for equity analysts to accurately predict bank profits, suggesting that investors may want to get used to the kind of volatility that follows earnings misses.
Last quarter, four of the Big Six banks – Toronto Dominion, Nova Scotia, CIBC and National – fell short of earnings forecasts as higher credit losses stemming from slower growth took a toll on income statements.
A contributing factor was new accounting rules that forced banks to disclose expected losses.
“Last quarter was a bit of a wake-up call,” said Rob Wessel, a former bank equity analyst who runs Toronto-based Hamilton Capital Partners Inc. “Analysts are going to have more difficulty forecasting earnings, and therefore there’s a greater chance of misses and beats.”
And when analysts’ forecasts are misaligned with actual results, stock volatility is sure to follow, particularly around earnings season. The banks’ next round of quarterly financial statements is slated for late May.
Last year, Canadian banks adopted the accounting rules known as IFRS 9, which were formulated after the global financial crisis to improve reporting on financial assets.
Rather than simply booking loan losses when they are incurred, the banks have moved to a model that estimates losses before they happen. It’s an imprecise process that requires banks to consider how macroeconomic and credit changes might affect their loan books.
In the banks’ fiscal first quarter, covering the rocky November to January stretch for financial markets, cuts to Canadian growth forecasts, combined with a steep decline in the price of crude oil, as well as the housing market slowdown, all factored into a rise in loan loss provisions, the amount of money banks set aside to cover bad loans.
TD’s loan losses rose to $850-million from $693-million in the same quarter last year, while CIBC’s increased by 121 per cent year-over-year to $338-million.
That order of magnitude reflects a moderation of economic conditions, rather than a significant deterioration, CIBC Capital Markets analyst Robert Sedran said.
“We’re at the point in the cycle where you should expect some noise on the loan-loss line,” he said, adding that credit losses have nowhere to go but up.
“When you’re at [a cyclical low in] loan losses, it creates potential risks.”
Mr. Wessel said another potential source of friction is likely to contribute to a period of heightened volatility for bank stocks: big acquisitions south of the border.
There has been little in the way of consolidation in the U.S. banking industry in the years since the financial crisis. But the proposed US$28-billion merger of BB&T Corp. and SunTrust Banks Inc. has led to speculation about a coming wave of deal-making in the United States.
“Seeing a deal that large get approved signals to investors that the regulators are comfortable with M&A,” Mr. Wessel said.
And for Canadian banks with big U.S. platforms, further expansion outside of Canada might make sense right now, said Norman Levine, the managing director at Toronto-based Portfolio Management Corp.
“The headwinds in Canada, between the consumer being so heavily in debt and economic growth looking to be substantially lower than in the U.S., are making U.S. acquisitions more attractive again,” Mr. Levine said.
The concern for Canadian bank shareholders, however, is that a large acquisition is a fairly reliable trigger for that bank’s stock to under-perform.
Last year, for example, the Bank of Nova Scotia’s buying spree weighed on its share price. Deals to acquire MD Financial Management and Jarislowsky Fraser Ltd. for a total of more than $3.5-billion coincided with Scotia’s stock falling by 16 per cent in 2018, good for second last among the Big Six.
The risk for M&A-driven under-performance is highest with Toronto-Dominion Bank, which has its eye on the Southeast U.S. market, has the necessary capital, and has not acquired a commercial bank in the region since 2010, Mr. Wessel said.
But Bank of Montreal, CIBC and Royal Bank of Canada are all potential acquirers in the near future, he said.
For committed, long-term bank investors, acquisition risk, just like volatility driven by loan loss accounting, should not be a deterrent, said Lieh Wang, chief investment officer of iA Investment Counsel.
“Where the market may take a negative view in the short term, I look at these reactions as buying opportunities.”