Too Late to Sell Bank Stocks?

August 01, 2022 | Jonathan Yung


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Mid Year Canadian Bank Review

Many developments have occurred since my last blog on the Canadian banking sector. This includes a Russian invasion of Ukraine, a climbing inflation rate that hit 8.1% YOY in June, a supersized 1% rate hike in July, and now many economists forecasting a recession for Canada in 2023. As a result, the Canadian banks have had a tough first half of 2022, with the big 6 Canadian banks averaging 10% losses for the year. Although this may not seem alarming, some banks have fallen 25% from their previous highs in February. Given the cyclical nature of the banking industry, the question on many investors’ minds may be: is it too late to get defensive on owning bank shares?

The next set of earnings results will come out in the middle of August. Based on the results received in May, the banks had not adjusted their forecasts for a potential recession next year. South of the border, the US banks have already reported their Q2 results with many building reserves and provisioning for larger credit losses to ensure they maintain their high credit quality. These prudent adjustments were well received by investors, with US bank stocks rewarded with a recent surge in buying.

Although the Canadian bank stocks are highly correlated, the magnitude of price movements will differ. When investing in Canadian banks, we feel it is important to spot the differences in the banks. Below, I walk through the characteristics that investors can look at to get a better gauge as to which banks could outperform their peers.

Economic Assumptions

Each bank uses their own economic assumptions to base their current and future operating decisions. A bank that forecasts greater GDP growth and low unemployment will likely have less loan loss reserves compared to a bank that has a more conservative outlook. This outlook may not match those investors who are expecting a softer economy ahead. On the other hand, those that feel the economy will be more resilient than feared would be attracted to banks with a similarly optimistic view. As Exhibit 1 shows, all banks except one have the assumption that Real GDP will fall.

Credit Quality

Credit quality is a critical consideration for bank investors during these uncertain periods. ‘Provisions for Credit Losses’ (PCLs) drive analyst expectations for earnings and will influence any revisions to their predictive models. In Exhibit 2, we can see that all the banks are either at or below their 2021 PCL levels. The greater the PCL, the more conservative a bank is being in their forecasts. Similarly, Exhibit 3 shows a comparison between each bank’s ‘Allowance for Credit Losses’ (ACL) and the actual impaired PCLs from the last twelve months. The larger the ratio between ACL and the actual PCLs, the better protected a bank is in case impaired loans begin to rise.

Loans are categorized in three stages, which each represent different degrees of default risk. Monitoring the risk of the loan book from each bank can be a useful exercise. Stage 1 loans are considered “performing loans” with low credit risk. Stage 2 loans have significant increases in credit risk from Stage 1 and are considered “underperforming loans”. Stage 3 loans carry the greatest credit risk and are considered “non-performing loans” with the greatest likelihood of impairment. The Exhibits below illustrate the proportion of Stage 2 and Stage 3 loans as a percentage of a bank’s total loans. Each bank has a different composition of loans. It is important to consider which type of loans carry the greatest risk as it may indicate its future recoverability and its likelihood of entering Stage 3.

Each bank has a fairly different loan book composition, which will have different implications for the bank’s performance depending on which areas of the economy are hardest hit.  A recessionary environment that causes a rise in unemployment will raise the risk of personal loans and credit card debt. In this scenario, a lower consumer loan exposure would be beneficial. However, a recessionary environment that sees increasing business closures will raise the risk of commercial loans. Commercial loans are typically larger in size than personal loans, and therefore the impact of defaults could be greater. Matching a bank’s loan mix with one’s view of how consumers and businesses will navigate the future economy is an important exercise to perform.

Valuation

Current valuation multiples for the Canadian Bank Index are near crisis-like multiples. During the financial crisis and the pandemic, the banks traded at 7.8x and 8.8x respectively. Currently, the Canadian bank index has a forward P/E of 9.4x, which we feel is low considering we do not feel that another banking crisis or economic shutdown is pending. Given that the banks are well capitalized, earnings estimates have been maintained, and the EPS has only dropped slightly below the March 2022 peak, the decline in bank stocks does not feel conclusively justified. Should inflation abate and the economy prove resilient, we feel bank stocks will perform well, especially under a new higher interest rate regime that is highly profitable for banking and deposit margins. The exhibits below showcase the bank’s valuations relative to their 1 year and 10 year average.

In our opinion, it may be too late to get overly defensive on bank stocks as a group. That said, investors should take a step back to compare and match one’s thesis on the economy to a bank stock’s valuation, credit fundamentals, and the bank’s own economic assumptions.  Speak to your advisor who can help review your bank stock positions and to help make any necessary adjustments.

 

 

 

 

 

 

 

 

 

 

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