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The Bank of Montreal and TD Bank towers on April 21 2020.

Fred Lum/The Globe and Mail

After large U.S. banks reported surprisingly strong first-quarter financial results last week, investors shrugged. Will quarterly results from Canadian banks next month be met with a similar reaction?

U.S. banks certainly delivered the goods. JPMorgan Chase & Co. reported a profit of US$14.3-billion during the quarter ended March 31, up nearly 400 per cent from the same quarter last year.

At Citigroup Inc. , profit was US$7.9-billion, up more than 200 per cent.

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Releasing financial reserves set aside last year – but not used – to cover bad loans during the early stages of the pandemic certainly helped. The banks also scored big from strong trading revenue and underwriting fees.

The banking sector beat analysts’ profit expectations by more than 40 per cent, laying the groundwork for what could have been a powerful rally.

But the KBW Nasdaq Bank Index , which tracks 24 U.S. banks, has retreated more than 2 per cent since the earnings season began last week, underperforming the S&P 500 by more than three percentage points – and raising the question of whether Canadian bank stocks will also struggle.

A key issue here is just how much good news has been baked into share prices, amid upbeat expectations for U.S. and Canadian economic growth this year.

Despite the recent pause, the KBW bank index is up 23.5 per cent since the start of the year, which is more than double the gain for the S&P 500.

Canadian banks have enjoyed a similar outperformance. The share prices of the Big Six banks are up 15.4 per cent year-to-date, beating the S&P/TSX Composite Index by about six percentage points. After looking cheap over much of the past year, bank stock valuations (based on estimated earnings) are now elevated and perhaps already reflecting good times ahead.

But U.S. bank financial results suggest that there might be another factor now holding up the rally: Loan growth and loan margins, which tend to excite markets more than capital markets activity or the release of financial reserves, were disappointing during the quarter.

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“We understand this is the primary reason why the U.S. banks have underperformed relative to the broader market for the last two weeks,” Paul Holden, an analyst at CIBC World Markets, said in a note.

Based on results from the U.S. diversified banks he tracks, loan growth was essentially flat between the fourth quarter and the first quarter, disappointing analysts’ expectations. At regional banks, loan growth shrank by about 1 per cent. Net interest margins, reflecting everything from credit card balances to mortgages, also fell.

Mr. Holden’s read-through for Canadian banks? They, too, should benefit from improving credit trends in Canada, giving them reason to release their own financial reserves eventually. They will likely reveal strong capital markets activity as well. However, the 2021 bank stock rally may also pause until the sector delivers loan growth.

Still, long-term investors who count on Canadian banks to deliver market-beating performance and rising dividends (on hold for the past year), have good reason to look beyond any stall in the rally. There is an entire year of potential improvement ahead.

Scott Chan, an analyst at Canaccord Genuity, noted that the commentary from U.S. banks after they reported results points to a pickup in loan growth in the second half of this year and into 2022. He also expects that U.S. banks will report fatter margins on loans, due partly to a rising yield curve (banks borrow money at low near-term rates and lend at higher long-term rates).

These improvements will have a direct impact on the U.S. operations of Canadian banks. They also imply better margins and loan growth in Canada, too, since the markets are similar, underscoring why observers draw conclusions from U.S. financial results.

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“Strong results from U.S. banks are an auspicious sign for their Canadian counterparts,” Hugo Ste-Marie, an analyst at Bank of Nova Scotia, said in a note.

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