Recent signs of a cooling Canadian economy led the Bank of Canada to hold interest rates steady this week, as anticipated. Canada's GDP for the second quarter fell short of forecasts, though factors such as the west coast port strike and wildfires were partly to blame. Nevertheless, some softening in the labour market and slowing consumer spending were also meaningful drivers. Below, we discuss some takeaways from the recently reported third quarter results of the Canadian banks, with a particular focus on their implications for the Canadian economy.

 

The Canadian bank results for this past quarter (ending in July) largely underwhelmed, reflecting a challenging operating and macroeconomic environment. Not surprisingly, most of the banks expect the economic backdrop to remain difficult, with projections pointing to weak economic growth and a modest uptick in unemployment this year.  The banks reported an expectation of a modest increase in home prices over the next twelve months, a revision from their earlier estimates of a decline.

 

The narrowing profit margins reported by most banks can be attributed to several key forces. First, net interest margin – the difference between interest revenue and interest expense – is showing signs of strain, suggesting that banks’ lending activities are less profitable. Second, higher interest rates have tempered the demand for loans, creating a general drag on bank revenues. Third, rising operating costs, notably those tied to staffing and technology investments, continue to present a challenge. Finally, nearly all banks continue to prudently add to their provisions for credit losses — a sign that they are preparing for more of their customers to have difficulty repaying their loans.

 

The banks’ credit loss provisions are forward-looking, and do not reflect a meaningful acceleration in actual credit losses to date. Delinquencies remain well below pre-pandemic levels. The increase in provisions reflects a return to normalcy, rather than a major shift in trend. The banks are preparing for loan losses to accumulate but have yet to see a major upturn.

 

Mortgages are a significant headwind facing many Canadian households. With the prospect of a prolonged period of elevated interest rates, households may have to grapple with higher mortgage payments in the months and years to come. Data from the Bank of Canada reveals that since the onset of rate hikes in early 2022, only about a third of mortgage holders have seen their monthly payments increase – a number that will continue to rise. By the end of 2026, nearly all mortgage holders will have refinanced at potentially higher rates. This, in turn, has implications for consumer spending. Homeowners with higher payments have less disposable income to support other areas of the economy. In addition, those who stretched to buy a home at peak prices could run into broader credit issues, given limited flexibility in leveraging existing equity or extending amortization periods.

 

In summary, both the Canadian economy and its banks are reflecting some of the lagged effects of tight monetary policy. We expect weaker loan demand to continue and for credit losses to eventually increase as more households and firms struggle with servicing their debts. We believe that future credit losses are a manageable risk for Canadian banks, given their mounting reserves. We see credit pressures as a bigger hindrance for the overall economy than for the banks themselves. We continue to manage portfolios with this expectation in mind.

 

If you have any questions, please do not hesitate to contact us.

 

Drew M. Pallett LL.B. CFP

Senior Portfolio Manager and Investment Advisor 

RBC Dominion Securities         

Email: drew.pallett@rbc.com

Website: www.pallett.ca