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Recession clouds are moving in and Canadian bank stocks are down, but the case for buying the dip has a serious flaw: Recessions tend to hit bank stocks a lot harder.

Share prices for the Big Six have tumbled nearly 12 per cent from their highs in early February, on average.

The declines follow Russia’s invasion of Ukraine, concerns about the housing market and fears that inflation-fighting interest rate hikes by the U.S. Federal Reserve and the Bank of Canada could derail the North American economy.

Large U.S. banks, whose first-quarter financial results earlier this month were weaker than a year ago, have been faring considerably worse than their Canadian counterparts.

The KBW Nasdaq Bank Index, which tracks 24 U.S. national and regional names including Citigroup Inc. and JPMorgan Chase & Co., has fallen 23 per cent since mid-January.

This dismal performance, which is a lot worse than the broader S&P 500, is raising questions about whether Canadian banks are due for a more serious correction.

“One big question we ask ourselves when facing economic/geopolitical uncertainty is whether investors are amply compensated for these risks. In our view, it’s still early to jump in with unbridled enthusiasm,” Gabriel Dechaine, an analyst at National Bank of Canada NA-T, said in a note.

Mr. Dechaine looked at the performance of Canadian bank stocks during the past five recessions, focusing on what happens to valuations when economic activity declines.

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In particular, he compared stock prices with book values, or assets minus liabilities. The takeaway: Recessions sent price-to-book ratios down by an average of 40 per cent from prerecession peaks.

During the current market jitters, price-to-book ratios for the Big Six have fallen just 11 per cent, as of April 24. This implies bank stocks are only partly reflecting an economic contraction.

“In other words, it would appear the market is pricing in about a 25 per cent probability of a recession. In comparison, U.S. bank stocks are pricing in about a 40 per cent probability of a recession using the same methodology,” Mr. Dechaine said.

That’s not the only reason he’s cautious about the sector right now.

The period when valuations compress tends to last about 14 months, on average. The current bout of declining valuations has been going for just two months so far.

As well, dividend yields are an important motivating factor for investors. However, yields don’t look as enticing when bond yields are rising.

The difference between the average yield on a Big Six stock and the yield on the Government of Canada 10-year bond – just 75 basis points, or three-quarters of a percentage point – is narrower than at any time over the past decade. The average spread is 2.4 percentage points.

“We’d need to see that spread at least get to a historical average in order to get more excited about the sector,” Mr. Dechaine said.

He is not the only analyst expressing reservations about Canadian bank stocks right now.

Paul Holden, an analyst at CIBC Capital Markets, pointed out recently that a recession could cause the sector to tumble 30 per cent.

Still, Mr. Holden and Mr. Dechaine acknowledge that a recession is a rising risk, rather than a done deal. And, of course, Canadian banks don’t necessarily follow in lockstep with U.S. banks.

Meny Grauman, an analyst at Bank of Nova Scotia BNS-T, argued in a research note on Monday that Canadian banks are actually better off than their U.S. counterparts in some key areas.

Their investment banking revenues at the Big Six tend to be less volatile.

Also, Canadian banks have been slower to release credit reserves built up during the worst of the pandemic. This gives them a relatively large capital buffer against a downturn, which helps explain why Canadian bank stocks have been outperforming U.S. banks this year.

“In our view, Canadian bank outperformance makes a lot of sense – as it reflects a number of fundamental differences that make the outlook for Canadian banks more positive than for their U.S. peers,” Mr. Grauman said in his note.

Yes, there’s a buying opportunity here. But the economy may dictate the timing.

Full disclosure: The author owns units in the BMO Equal Weight Banks Index ETF.

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