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Canadian banks tarred with Europe’s brush

European bond market upheaval this morning highlights a depressing trend for Canadian investors. You can basically throw the recent quarterly bank earnings results out the window, because Canadian bank stocks remain lashed to the mast of European credit issues.

Domestic banks stocks are likely to open lower this morning despite last week's strong (if mildly problematic) set of quarterly earnings. Once again, the problems stem from Europe. The announcement that Italian Prime Minister Mario Monti is set to step down was met immediately with a market sell-off that sent two year Italian government issues lower by almost a full percentage point.

This chart shows why that's bad news for domestic bank stocks. The S&P/TSX Bank Index retains a remarkably high correlation with European government bond markets despite no evidence of direct holdings of European debt by Canadian banks. It appears the market's primary lesson from the global financial crisis is that no matter what is disclosed on bank balance sheets, the contagion effects of credit issues are likely to spread across continental borders when things get tense.

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Canadians are justly proud of the country's stable banking system and having stock performance limited by miscreant bankers and policy makers halfway across the globe is maddening. But until some form of credit and banking stability is engineered in Europe it seems that investors will have to live with it.

More positively, Canadians can hope that resumption in profits from the domestic banking sectors is only delayed. Patient investors in the sector can collect dividends now and benefit from the eventual pop in stock values when global financial concerns wane and individual banks can once again be judged on their own merits.

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