Dear Friends,

I hope your week-end was a good one.

A tug of war has emerged this year in global markets. On one end, a view that tight financial conditions will eventually lead to a recession and equity market weakness. On the other side, the belief that a resilient economy will lead to stickier inflation and force central banks to raise rates more than expected, which could extend the weakness across asset classes we saw last year. The latter view has been more prevalent of late given stronger economic data through the first few months of the year. We expect sentiment to oscillate from one view to the other over the months to come as data trends inevitably change. In time, we expect tight financial conditions to eventually weigh on economic activity.

This week, we take a step back from the broad market narrative, and focus instead on the Canadian banks, which reported results recently. We often closely assess this group because it’s at the core of the financial and economic ecosystem, and can provide helpful information on the state of the consumer, businesses, and financial conditions. It also remains such a large part of the domestic equity market, and not surprisingly, an important part of the portfolios we manage for our clients. As usual, there were stock specific issues tied to each bank’s results this past quarter. However, there were a few broad takeaways. We share them below.

First, it appears the tailwinds of rising interest rates that had benefitted the banks over the past year are set to fade to some degree as growth in net interest margin (the difference between interest revenue and interest expense) is expected to moderate as the year progresses. Second, credit trends looked to be just fine this past quarter, with no real evidence of any deterioration. Moreover, while the banks are preparing for credit losses to eventually increase, they remain confident in the diversification of their loan books and don’t expect to see much in the way of stress. Finally, capital levels, which can be regarded as the armour on the balance sheets of the banks, remain relatively solid, which should reassure investors that the banks have the ability to withstand future credit losses.

From our vantage point, the results and commentary from management teams confirm that the current backdrop and health of the overall consumer and businesses remains reasonably good. Nevertheless, the Canadian banks continue to trade well below their historical averages. This suggests the market has some concerns. More specifically, there are two issues weighing on valuations. First, more scrutiny and pressure from government and regulators that has resulted in higher taxes and capital requirements. This has and may continue to limit the earnings power of the banks. Secondly, concerns over credit as a combination of much higher interest rates and an indebted Canadian consumer may eventually lead to a more challenging credit cycle.

We appreciate the issues described above. And, we wouldn’t be surprised to see weakness in bank stocks once an acceleration in loan losses begins. But, these concerns are already reflected in current bank stock valuations, leaving us comforted to some degree. As always, the possibility exists that a downturn could be worse than expected, and that’s the scenario that would have us more concerned. As a result, we have to be prepared to reassess our views and convictions. In the meantime, the dividend yields of the banks continue to offer some refuge, with yields ranging anywhere from 4-5% on average. Those levels are not necessarily as compelling as they used to be relative to bonds. Nevertheless, they still represent a reasonably attractive source of income. As a result, we believe the Canadian banks will continue to play an important role inside our clients’ portfolios.

Should you have any questions, please feel free to reach out.

Have a great week.

Best Regards,

Frank