In 2021, I published a blog titled, Banking on Dividend Increases, where we reviewed the investment case for the banking sector based on dividend payouts, capital levels, and valuation. Since then, the Canadian banks performed exceptionally well and returned over 30% last year (see chart below). This group has continued this strong momentum into 2022 and so far has been one of the few bright spots within the TSX index.
Given the recent outperformance, many have questioned whether this uptrend is sustainable. In the recent banking analyst report, RBC Capital Markets (RBC CM) maintains a constructive outlook on this sector. This is attributable to the sector’s dividend increases, stock buybacks, increased profitability, and valuation support. We will dive deeper below.
Dividend & Stock Buybacks
From the earnings report in Q4 2021, the banks announced an average dividend increase of 15.5% and 2.6% of shares to be bought back. A higher dividend satiates the demand for yield investors and the share buybacks help reduce the overall share count that helps boost earnings per share. RBC CM also states that they expect dividend growth in the high teens for 2022.
Earnings Growth
The analyst at RBC CM believes “Provision for credit losses” (PCLs) should be lower for longer. The banks still have over 50% of pandemic credit provisions to release since loan losses were much lower than originally feared. This action will be positive for earnings.
‘Net Interest Margins’ are also expected to increase as central banks will raise rates in 2022. Banks tend to be more profitable when net interest rate margins increase because banks can charge higher rates on loans relative to the outgoing interest it pays to depositors. As the chart below shows, the trajectory of Net Interest Margins is expected to consistently rise. A post-omicron environment also raises the expectation for a strong economy, which can bring forth a rise in increased loan growth. RBC CM forecasts a 7.8% increase in loan growth in 2022, which is up from the 5.4% loan growth witnessed in 2021. This rise in loan growth will also add to overall earnings growth.
Valuations
On a valuation basis, the banks are hovering slightly above their long-term average Forward PE ratio of 11.4X. Although the bank stocks cannot be considered cheap, it seems reasonable to us that the banks would stay at the higher end of the valuation range. As the chart below shows, banks have historically commanded a 10.5X to 12.5X Forward PE when the 10 year Canadian Government Bond rate was below 5%. Presumably, in an environment where the government rate crosses over 5%, the Bank of Canada is likely in an aggressive rate hiking environment and the prospect of a cooling economy or recession is more likely. In this scenario, bank valuation multiples are likely going to decrease. All this being said, with the current 10 Year rate only at 1.78%, the banks may have the time and opportunity to stay or grow into even loftier valuation multiples.
Overall 2022 should continue to be constructive for the Canadian bank sector. Still, there may be some regulatory risks ahead as the Liberal Government has proposed increased taxes for the major banks as well as a payment towards a recovery fund called the Canada Recovery Dividend. Although these measures could take hold as early as this year, RBC CM estimates the impact on earnings may only be around 3.8%. Therefore, during a year that is expected to be riddled with volatility and uncertain central bank policies, we still expect the banks to be able to provide some stability with their strong dividend, earnings growth, and fair valuations.