First Quarter Bank Earnings
In my note on August 25, 2020, I highlighted the role bank earnings play in assessing the health of the economy, businesses and consumers (see link). Looking to these results has remained an important exercise in determining how we’re positioning client portfolios for the rest of 2021 and beyond. Canadian banks stock prices have performed well to start 2021 and that trend continued last week as they reported first quarter earnings for the period November 2020 through January 2021. The details within the earnings results highlight two main themes about what to expect going forward.
i) Revenue and earnings growth
Credit concerns are fading so the headwinds from the funds set aside for bad loans should decline. As well, the reopening of economies should act as a meaningful tailwind for growing bank revenues. This will likely prove more significant as the year progresses as more businesses and consumers gain confidence in their ability to invest and spend, and therefore, require banks’ products and services. Earnings growth is also anticipated from rising yields as the margins between bank lending and bank borrowing rates expand.
ii) Valuation lift from current levels
Current valuations for banks remain inexpensive. As the operating environment continues to improve and growing revenues translate to upside in earnings expectations, we can expect banks to continue their rise in price. This valuation lift will be aided further by the return of increases to bank dividends, potentially before the end of the year.
From these latest results on the Canadian banks, and their reflection on the health of the broader economy, investors should be feeling more confident on what lies ahead.
Rising Yields and Inflation
There is a dynamic relationship between central bank interest rate policy and the markets’ ability to anticipate the future path of rates. Policy is intended to read the current state of the economy and establish the level of interest rates, and provide a forecast for future direction. The goal is to stimulate the economy with low rates in difficult times and prevent the economy from overheating with higher rates during boom times. The market can have a significant influence on this. In the late summer and early fall of 2018, the US Federal Reserve increased interest rates and indicated further rates were likely through the fall and into early 2019 in response to what they believed were strong growth signals and the possibility of rising inflation. The markets believed this was too soon and too fast, and responded in a way that forced the Federal Reserve to reverse course.
This dynamic continues at play today, however it’s the markets taking the lead. The market is putting selling pressure on longer term bonds, causing interest rates to rise. In fact, these rising longer term yields are suggesting central banks will have to begin hiking rates sometime in late 2022 versus prior expectations for mid-2024. The suggestion is that rates are rising in anticipation of higher levels of inflation in the coming quarters. Pressures from rising inflation have widespread effects across equity and fixed income markets as interest rates will need to be increased to control prices of goods and keep economic growth under control. The Federal Reserve’s response to markets pushing yields higher is going to be important to monitor. It needs to be determined whether the rise in yields is due to fears of future inflation or simply changes in growth expectations for the next several periods. Yields remain historically low, and while they have moved materially since August 2020, they are just back to where they were before the onset of the Covid-19 pandemic. And while some inflation is expected this year as a result of economies reopening and the return of both business and consumer spending, it may remain within target levels and prove to be temporary as current circumstances are far from normal.
Online Trading Frenzy
Much has been made of the recent volatility created by extreme swings in the prices of a few, smaller companies. This had initially unsettled the markets and caused speculation about whether there were material implications to this activity that had to be taken seriously. Could a large online community and a wave of retail money, a result of no-cost trading, government handouts and low borrowing costs, change how markets operate? Could a segment of investors paying more attention to themes and headlines than to balance sheets and company fundamentals be an emerging trend? While I’ve spent little time worrying about the longer term impact of this noise, I have enjoyed reading some the commentary and anecdotes that others have provided, including:
- An article on Jaime Rogozinski, founder of Reddits WallStreetBets community
- A recounting of events of January 26
- PigglyWiggly – the story of one man taking on Wall Street alone