Weekly Up-date

May 25, 2021 | Dany Hughes


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Overall, markets were unchanged or modestly higher over the past week. Some of the inflation-fueled concerns subsided in recent days, helping to revive the high growth parts of the market that have bared the brunt of the latest bouts of pressure. Canadian investors are likely to turn their attention to the financial sector over the next week, with the banks set to report quarterly results. Earnings should be strong, but the question is whether they will be good enough to meet elevated expectations? Regardless, the intermediate-term outlook remains positive for the sector, which we discuss below. We also provide a brief update on a much improved Covid situation in this country.

 

Coronavirus update

Canada experienced one of its largest declines in new daily infections this past week. The country’s 7-day average rate of new daily infections stands at 5000 versus 6700 from the week ago period. Nearly all regions across the country experienced meaningful improvement. For example, Alberta’s average rate of new daily infections fell by 40% in the past week alone. Manitoba remains the one province that has yet to show significant declines, though its figures did not increase over the past week which could mark an important inflection point for the province going forward. Many provinces are now preparing to ease restrictions in the weeks to come, which comes as a welcome relief to many and should bolster the economic tailwinds going forward.

 

Canadian Banks Expected to Report Good Results

The Canadian banks have performed well year-to-date, with share prices rising by roughly 20% already. That group is now well above where it traded before the pandemic began. The strong performance in recent months has raised expectations with respect to the strength of future earnings and dividend growth. Nevertheless, there are a host of reasons to remain optimistic.

 

Earnings growth this quarter is expected to be up by well over 100% year over year as the companies benefit from a better operating environment relative to the year ago period. Last year, the companies were aggressively building reserves to prepare for anticipated loan defaults. Those credit losses have yet to materialize as government programs and other measures aimed at helping households and businesses limited the economic damage. Moreover, while conditions remain far from normal, the companies are no longer building reserves and provisions for credit losses are now declining year over year. That trend should continue, with the banks ultimately releasing reserves once economic uncertainty has faded from the outlook, which could add a further tailwind to future earnings growth.

 

Most banks have capital markets franchises and wealth management operations that could deliver strong results in the near-term. They may benefit from a favorable market backdrop that has been characterized by rising asset prices, high levels of capital raising, and volatility, particularly in the bond market that may drive strong trading results.

 

One key source of profitability that is expected to remain challenged for now is net interest margins. This source of earnings is generated from the spread earned between net interest revenue, typically from loans to customers, and net interest expense, or the interest paid to customers who deposit funds at a bank. Currently, deposits remain unusually elevated, driven by a combination of financial assistance programs and low spending given large swaths of the economy remain partially closed. The latter issue has also resulted in relatively weak loan demand. Net interest margins are unlikely to improve in an environment where deposits materially exceed loan levels. But, assuming Canada continues to see an improving trend with respect to the virus and the easing of restrictive lockdowns, it may just be a matter of time before this important source of earnings begins to finally accelerate.

 

On the dividend front, not much may change in the near-term. The Office of the Superintendent of Financial Institutions (OFSI), which is Canada’s banking regulator, implemented restrictions last year on share repurchases and dividend increases for the sector. It has reiterated that stance in recent months, and is expected to provide a more official update next month. It may want to wait for a more sustainable economic recovery to unfold before permitting the banks to deploy their capital towards shareholder-friendly initiatives. With the banks targeting dividend payout ratios of 40-50% of earnings, there is potential for dividend increases over the next couple of years once the restrictions have been lifted.

 

Despite the strong run the Canadian banks have had year-to-date, the valuations relative to measures such as book value and forward earnings are not excessive. And while investors may have to wait for their dividends to be increased, the patience may prove to be rewarded given the strong earnings growth and operating environment that appears poised to continue to improve.