Investor attention has turned to Canada over the past few weeks due to a slew of economic releases and earnings reports from Canadian banks. Below, we discuss key takeaways from these developments and reflect on the Canadian equity market’s performance this year, along with some thoughts on the outlook.

 

Over the past week, Canadian banks reported their second-quarter results. Much of the focus has understandably been on the outsized stock price reactions. Typically, any moves in the Canadian bank stocks related to earnings results are relatively tame and within a few percentage points of each other. But this time around, some banks saw substantial declines in their stock prices, while others were rewarded with meaningful gains.

 

We have been more preoccupied with what the earnings and management commentary suggest about the state of the Canadian economy, its consumer, and overall credit conditions. Apart from one bank, most Canadian banks reported loan losses and provisions for future loan losses in line with expectations. There continues to be an uptick in credit card and auto loan delinquencies, and some banks flagged growing vulnerabilities among certain variable-rate mortgage holders. Overall, the Canadian consumer was characterized as reasonably healthy, with pockets of stress in certain areas. We would describe the credit environment as one that continues to gradually deteriorate, but not in a disorderly or concerning manner. While this represents a headwind to the banking sector, it has been anticipated for some time and is reflected in the sector’s below-average valuation.

 

Elsewhere, recent Canadian economic data has not been overly surprising. Inflation continues its descent, with CPI for April down to 2.7% from 2.9% in March and 3.4% at the end of last year. Economic growth remains modest, largely driven by significant population growth from immigration. Closer examination of the growth numbers reveals that real GDP per capita has fallen over the past year and a half as businesses and households cut back on spending in response to higher borrowing costs. Both the manufacturing and services sectors have seen subdued activity over the past few quarters, with consumer demand weakening as budgets tighten and the labour market softens.

 

Yet, despite the soft economic backdrop and tight credit conditions facing Canadian businesses and households, Canadian equities have performed reasonably well year-to-date. This is partly due to growing conviction that inflation in Canada is on track to return to the 2-3% target range, raising expectations that the Bank of Canada might soon lower interest rates. A first cut is expected in either June or July. Additionally, strong performance across a range of commodities – including energy, copper, gold, uranium, and nickel, to name a few – has boosted the Materials and Energy sectors, which together account for close to 30% of the Canadian equity market.

 

Notwithstanding the gains made over the past year and a half, the valuation of the Canadian stock market sits just below its historical average. This seems reasonable given the challenging near-term domestic economic outlook. While sentiment may continue to improve with a further decline in inflation and the beginning of rate cuts, we believe a turn higher in the economic and earnings cycle may be required to drive a more prolonged period of stock price gains. Given the lagged effects stemming from changes to interest rates, we see this as more of a possibility beyond the next year.

 

Should you have any questions, feel free to reach out to us personally at trevor.hodgins@rbc.com or ahsen.ansari@rbc.com.