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Economy Oil slump weighs on Canadian bank stocks as Big Six report earnings

The King St. West entrance to the Bank of Nova Scotia in Toronto. The bank will report its quarterly results on Friday.

Fred Lum/The Globe and Mail

Canadian banks are facing a tough economic environment, raising some uncertainty among observers over what the Big Six's quarterly financial results will look like this week.

At home, oil prices are in the dumps and Canada's economy has contracted for five straight months. Abroad, ongoing worries about Greece's position within the euro zone and China's recent decision to devalue its currency are raising alarms about the health of the global economy.

"There has been no summer slowdown insofar as the news flow related to the Canadian banks is concerned," said Sumit Malhotra, an analyst at Bank of Nova Scotia, in a note. "Unfortunately for the sector, the headlines have only added to the negative sentiment that has weighed on stocks in 2015."

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Bank stocks have slid more than 11 per cent since April, hitting 18-month lows. Valuations, based on earnings expectations, have also fallen sharply over the past several months, to levels that reflect some pessimism about the sector's growth prospects.

Indeed, analysts expect third-quarter bank earnings will rise by an average of just 2 per cent over last year – a cautious forecast that will be tested over the next several days.

Bank of Montreal kicks things off with its results on Tuesday; Bank of Nova Scotia wraps things up on Friday.

"Notwithstanding the weak share price performance so far this year, we believe the market is concerned about the outlook, but not expecting much bad news this quarter," said Robert Sedran, an analyst at CIBC World Markets, in a note. "In other words, good news is not news … bad news is bad news."

At the start of the year, the biggest concern facing banks was the impact of weak oil prices and whether Canada's depressed energy sector would drive up loan losses – a concern that largely faded as the banks assured investors that all was well.

However, the concern has returned: The price of oil is exploring new six-year lows after falling more than 30 per cent this summer, and analysts have noticed that bank stocks are following the commodity's lead.

Mr. Malhotra said that the Big Six banks had a total of $44-billion in loans to energy producers at the end of April, representing just 2 per cent of their aggregate loan portfolio. This suggests that rising impairments and loan loss provisions shouldn't have a meaningful impact on bank results.

But the bigger question is how low energy prices are affecting the Canadian economy, which is already showing signs of heading into a technical recession, defined as two straight quarters of contraction.

Given that banks are highly sensitive to economic activity – people worried about their jobs tend not to look for mortgages – a worse-than-expected economic downturn could drive bank stock valuations even lower.

"We think that forward earnings estimates do not fully capture the credit costs that would start to pile up if Canada's imminent technical recession turns into a real one," said Peter Routledge, an analyst at National Bank Financial, in a note.

"Simply put, we remain cautious on the sector because we think consensus estimates may start to deteriorate and this deterioration may cause further compression in sector price-to-earnings multiples."

In other words, cheap stocks could get cheaper.

Not all forecasts are gloomy, though. Darko Mihelic, an analyst at Royal Bank of Canada, believes that his estimate of 2 per cent growth in earnings, on a per share basis, could prove conservative given several positive trends for earnings.

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Loan growth in Canada is accelerating, according to industry data; the banks raised fees earlier this year, taking effect in the third quarter; growth trends among U.S. banks looked good in their most recent quarter; and banks are controlling their expenses, with Toronto-Dominion Bank and Scotiabank in the midst of restructuring efforts.

"In our view, fundamental trends look positive heading into the third quarter [reporting season] and we believe there could be near-term upside to the stocks if our quarterly estimates prove to be conservative," Mr. Mihelic said in a note.

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