Markets will be focused on the political circus around the U.S. "fiscal cliff" in early 2013, but Canadian investors should keep their eyes fixed on two lesser known stories that have the potential to dominate domestic headlines as the year progresses.
The first is a slowdown in the profitability of Canadian banks. This is, to some degree, a global phenomenon. Central banks around the world have engineered low interest rates to support economic growth but those low rates are severely limiting bank profits from the core business of lending.
Banks make money on the difference between what they pay on short-term deposits and what they charge borrowers for long-term loans. The broader this gap, the better for banks' profits. As recently as 2010, the difference between short-term and long-term rates was more than 3 per cent. Today, it's less than 1 per cent. Banks are paying almost as much in interest payments as they are receiving from lenders.
To compensate for lower profits on lending, Canadian banks have expanded their operations in more cyclical businesses such as capital markets trading and credit cards. Bank of Nova Scotia, for instance, has doubled credit card revenue since 2006. Year over year, Royal Bank has tripled its revenues from bond trading and investment banking.
All of this leaves the banks highly sensitive to any slowdown in market activity or consumer credit. The combination of outsized household debt and a slowing real estate market is likely to reduce profits from loans further in 2013, squeezing profit growth for all the major banks.
Canadian banks are going to come under pressure, but China's banks face an even more treacherous outlook. Wealth management products (WMPs), a form of short-term savings vehicle, have come from nowhere five years ago to represent $2-trillion (U.S.) or 15 per cent of the country's bank deposits. Credit rating agency Fitch Ratings has warned of the possibility that interest payments on some WMPs are being funded by sales of new products rather than through returns they have generated on their own.
According to Beijing-based Caixin Media, the recent default of a relatively small WMP caused a near riot in Shanghai. China's Ministry of Finance is attempting to limit the growth in WMPs, particularly those issued by arms of local governments, but this may expose the already treacherous financial health of governments in many regions. If so, expect the volatility in China's financial system to be reflected in commodity prices and the share prices of many Canadian miners.