Domestic investors were skeptical when a major investment bank advised clients to short-sell Canadian bank shares and using the proceeds to buy U.S. banks. Nonetheless, the idea was remarkably lucrative. A look at the numbers will tell us why, and whether the trend is sustainable.
Michael Hartnett, Chief Global Equity Strategist at Merrill Lynch, first recommended the trade to sell Canadian financials and buy U.S. in early 2013. The reasoning had nothing to do with financial health – Canadian bank balance sheets remain far stronger than their U.S. counterparts – and everything to do with the fact that the two countries are at much different stages of the economic cycle.
Investors that heeded Mr. Hartnett's advice on this long-short bet have generated a tidy 22.8 per cent net return to date in 2013. (see chart). The 4.6 per cent appreciation of the U.S. dollar versus the loonie increases the profits on the trade to 27.4 per cent.
Record levels of Canadian household debt and a near-exhausted housing price boom suggest that domestically, the credit cycle is in its seventh or eighth inning. South of the border, consumer debt deleveraging has already occurred – the U.S. debt service payments to disposable income ratio has declined to levels last seen in the early 1980s.
The U.S. consumer has ample room to expand their balance sheet with debt and spending. Domestically, debt levels suggest the consumer is almost tapped out.
Mr. Hartnett believes that another surge in U.S. borrowing, one that will boost profits for the banking sector, is now underway. This belief was amply supported by consumer credit growth in May, which came in $7.1-billion (U.S.) higher than economists expected, at $19.6-billion.
The valuation case for U.S. banks relative to Canadian banks remains compelling. The KBW Bank Index trades at 1.1 times book value, a 75.5 per cent discount to 2006. The S&P/TSX Canadian Bank Index, on the other hand, is 1.9 times book value or 54.3 per cent of pre-crisis levels.
Canadian bank stocks deserve a premium valuation multiple. They are more diversified, more dominant within the economy and, for now, have more reliable balance sheets. But the U.S. credit cycle is at a far earlier stage than Canada's and American consumers are in a much better position to borrow. As a result, U.S. bank profits and stock multiples have much more room for expansion.
I'm not suggesting that Canadian investors sell all of their domestic bank holdings to buy Goldman Sachs. But for part of a portfolio, U.S. banks offer currency diversification, higher growth potential and a means to sidestep an inevitable consumer credit pullback in Canada.