DIARY OF A PORTFOLIO MANAGER

Unlike the weather outside this past week, we are seeing signs of a cooling Canadian economy and this 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 port strike and wildfires were partly to blame. Nevertheless, some softening in the labour market (yet we saw a better than expected number announced this morning) and slowing consumer spending were also meaningful drivers.

Canadian Banks

Investors love the banks even when they are a drag on the index. Royal Bank came close to $150 per share at its all-time high in January 2022 and it is now $120. 20% decline.

What are some of my takeaways from the recently reported third quarter results of the Canadian banks? I view them with a particular focus on their implications for the Canadian economy.

The 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 backdrop to remain difficult, with projections pointing to weak economic growth and a modest uptick in unemployment this year. However, banks now assume positive growth 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 two 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. Coupled with this, higher interest rates have tempered the demand for loans, creating a general drag on bank revenues. Operational costs, notably those tied to staffing and technology investments, continue to present a challenge.

Nearly all banks continue to prudently add to their provisions for credit losses — a sign that they’re preparing for more of their customers to have difficulty repaying their loans. These provisions also contributed to the underwhelming results as they get deducted from earnings. However, the provisions do not suggest that there has been a meaningful acceleration in credit losses. Delinquencies remain well below pre-pandemic levels; the uptick to date reflects more of a return to normalcy rather than a major shift in trend. In other words, the banks are preparing for loan losses to accumulate, but have yet to see a major upturn.

The chart below indicates that banks in a spot where they present a decent buying opportunity.

From tailwind to headwind

A big headwind facing Canadian households is on the mortgage front. With the prospect of a prolonged period of elevated interest rates, households may have to grapple with rising mortgage-related 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.

First, homeowners with higher payments have less disposable income to support other areas of the economy.

Second, 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 may be starting to show some of the lagged effects of tight monetary policy. RBC expects weaker loan demand to continue and for credit losses to eventually build as more households and firms struggle with servicing their debts. I’ve often said that what concerns me is how much money people are spending that they don’t have. This may take time to play out rather than occur in one fell swoop. Even though this poses a risk for banks, I am not overly worried as I believe it is a manageable one given the banks’ mounting reserves that continue to build for such a scenario. As a result, we see these pressures as posing a bigger hindrance to the overall economy than for the banks themselves. As always, I manage your portfolios with this expectation in mind.

Have yourself a great weekend,

J. Todd Kennedy, CIM, FCSI

Senior Portfolio Manager

613-566-4582

toddkennedy.ca