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Inside the Market Cheer up TSX bank investors: the one earnings number that truly matters is flashing a buy signal right now

The third-quarter earnings season for Canada’s big banks underscored something that investors should embrace: The banks’ bread-and-butter lending activities are still gushing money.

Sure, lending money to Bob and Mary for their first bungalow sounds like a sleepy activity next to backing corporate takeovers and underwriting splashy initial public offerings – and, yeah, there are lingering concerns about the housing market and indebted Canadians.

But the scale of this lending activity is really something to behold, and it is driving up net interest income, or the difference between what a bank pays for deposits and what it makes on loans, at an impressive clip – good news for any bank investor who wants bigger earnings and quarterly dividends.

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“There is much discussion about net interest margin, deposit betas, loan spread compression, loan volumes, deposit growth … but the only thing we believe truly matters is growth in net interest income, the largest revenue line. It is growing well and looks set to continue to do so into next year,” Robert Sedran, an analyst at CIBC World Markets, said in a note.

In their third quarter, which ended July 31, net interest income among the Big Six banks increased by an average of 8 per cent, year over year. That's feeding dividends, which are also rising at an 8-per-cent annualized clip.

But bank stocks have been lagging these sound fundamentals in 2018, amid concerns about high levels of consumer indebtedness, new regulations for the housing market and concerns about the North American free-trade agreement.

So far this year, the S&P/TSX Commercial Banks Index has risen less than 2 per cent (not including dividends).

There are several reasons why this level of caution is unwarranted.

First, concerns about the housing market, which once propelled U.S. short sellers convinced that Canada was on the verge of a U.S.-style downturn, are subsiding as home sales stabilize following a downturn earlier in the year. Nationally, home sales increased 1.9 per cent in July, compared with June, and were down just 1.3 per cent year over year, according to the Canadian Real Estate Association.

What’s more, household debt levels as a share of disposable income retreated to 168 per cent in the first quarter, down from 169.7 per cent in the previous quarter.

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Sure, that’s a slight decrease. Nonetheless, it’s a move in the right direction, and it is something that Moody’s Investors Service cited when it revised its outlook for the Canadian banking system to “stable” from “negative” in a report on Wednesday.

The improvement, Moody’s said, “incorporates the stabilizing effect that recent macro-prudential measures and rising interest rates have had on housing prices in Canada's major urban areas, helping ease the pressure on household finances.”

Second, those rising interest rates are good news for banks.

“The banks have entered a phase where interest rates have come off their lows, boosting margins, but remain historically low, supporting loan growth,” Mr. Sedran said.

He calculated the big banks’ sensitivity to expanding net interest margins, a measure of loan profitability. A margin expansion of just two basis points (there are 100 basis points in a percentage point) would drive bank profits up by an average of 1.4 per cent on a per-share basis. A 10-basis-point expansion would drive profits up by an average of 6.8 per cent.

Although the Bank of Canada held its key interest rate unchanged on Wednesday, at 1.5 per cent, many observers believe it will raise its rate to 1.75 per cent in October.

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And third, the biggest banks are demonstrating that their size adds diversification and stability, in stark contrast to some of their smaller competitors.

Canadian Western Bank, whose market capitalization is just $3.1-billion compared with a Big Six average of $89-billion, has been recovering from a recent recession in Alberta, but its volatile share price has given investors a wild ride over the past three years.

Laurentian Bank of Canada, with a market cap of just $1.8-billion, is also a turbulent stock. After reporting disappointing financial results and weak guidance on Tuesday, the shares slumped toward a two-and-a-half-year low amid analyst downgrades. The shares have fallen 29 per cent since November.

The big banks may be drifting sideways this year, but their financial results suggest a considerably better future.

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