What to do with Canadian banks?

The yields look good, but the risks are real, and it could get worse before it gets better

Ruth Saldanha 19 March, 2020 | 1:47AM
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Bank in Canada

Editor's note: Read the latest on how the coronavirus is rattling the markets and what you can do to navigate it.

Fears around COVID-19 have spilt over into the markets. Since the start of the month, the S&P/TSX Composite index has lost around 30%, and more and more experts believe a recession is likely. To stave it off for a while longer, both the Bank of Canada and the U.S. Federal Reserve announced rate cuts and easing measures, with more expected in the next month. 

The Fed announced a series of measures to "support the flow of credit to households and businesses," including: lowering its discount window rate; reducing reserve requirements for banks to zero; encouraging banks to tap into capital and liquidity buffers, when needed, to support lending to households and small businesses; and the extension of intraday credit to banks as needed. While there are quite a few moving parts in the Fed's actions, the most notable and consequential is the drop in rates to zero, which will hit net interest income for a slew of financial firms, and weigh on money market managers who will likely have to resort to fee waivers.

Meanwhile, the Bank of Canada said it will start purchasing around $500 million a week in mortgage bonds and accept a wider set of securities in its term repo operations, it will acquire up to $50 billion of government-insured mortgages, will allow a greater percentage of collateral to be in the form of non-mortgage loans, and will expand the scope of a bond buyback program in which it sells newer, more liquid bonds for older issues.

What does this mean for bank stocks?
Despite these moves, Canadian banks have seen a selloff. The Solactive Equal Weight Canada Banks Index, which comprises of the big 6 banks, is down over 30% since last month.

“The selloff in Canadian bank stocks took a lot of investors by surprise, and it was largely a result of a broad selloff in financial stocks and growing concerns about the health of the Canadian economy,” says Mark Noble, EVP of ETF Strategy at Horizons ETFs. He points out that in terms of quality cash-flow and diversified sources of revenue the banks remain well-positioned and currently have a high dividend yield by historical standards.

However, Morningstar equity analyst Eric Compton does not like Canada right now as much as the U.S. “In Canada, the consumer is more indebted, so the system overall seems a little more stretched, which you don’t want when the system starts to face more stress. Canada is also more oil-dependent in certain regions for the economy. The Canadian banks also don’t look quite as cheap,” he says.

Noble counters this by pointing out that typically, the Canadian banks have been much more well-capitalized than the U.S. banks with less aggressive lending and stricter capital requirements, which is why the historical volatility of the Canadian banks has been much lower than the larger U.S. banks.

Risks to Canadian bank stocks
“Canadian banks are probably a little more exposed to Real Estate lending than the U.S. banks at this point given that our Real Estate market never declined to the same extent as the U.S. market. If we do go through a full-on real estate correction, something we sidestepped in 2008/2009, it’s hard to know what impact that would have on the Canadian banks. Add to this the relative risk economic risk in Canada due to the rapid decline in energy prices which could hurt the Canadian economy greater than the U.S. and there are some real risks with the banks right now,” Noble warns.

“The real issue is going to be what happens if/when businesses and consumers face a cash shortfall. When no one is spending money, businesses aren’t generating the revenues they expected, but they still have to pay employees, pay the rent, etc., so what happens if companies which didn’t have any real issues start running into cash shortfalls and then either defaulting or firing employees to save money in the short term. This would cause credit costs for banks to rise, and also cause unemployment to rise, which would put pressure on Canadian households. That’s what I would be worried about, how does Canada, and the world, navigate the next month or two of people having to stay home, supply chains being shut down, and a totally unexpected lack of demand in the economy,” Compton says.

Should you buy?
In the immediate term, it’s hard to say what will happen next. However, the attractiveness of the Canadian Banks stems from their yields, which earlier this week were all above 5%, Noble says. “A lot of pain is now priced into the Canadian Bank prices, even if the prices don’t appreciate from here, investors are being compensated with an attractive yield especially in an environment where sources of yield are going to be more scarce,” he says.

“We do know that bank earnings will come under pressure in the short term as rates move to near zero. Having already updated most of our bank valuation models after the last rate cut just two weeks ago, we're going to hold off on updating them until we get clearer guidance from bank management teams during the release of first-quarter earnings,” Compton says.

“The Canadian banks have been a solid bulwark of Canadian portfolios and could potentially be viewed as a safe-haven income equity asset for income-focused investors,” Noble says.

Compton does agree that the Canadian banks are looking cheaper, but most aren’t in five-star territory yet. “I think they are worth considering at today’s prices, but investors should realize it can get worse before it gets better. Royal Bank of Canada and Toronto Dominion are the two highest quality franchises, I would give them a look first,” he says.

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About Author

Ruth Saldanha

Ruth Saldanha  is Senior Editor at Morningstar.ca. Follow her on Twitter @KarishmaRuth.

 
 
 

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