Canadian Bank Pre-Earnings: What to Look for in the Bank Results

Ruth Saldanha: Later this month, the Canadian banks will be reporting their latest quarterly earnings. So, what can we expect from the banks this time around? The three big things that Morningstar analyst Eric Compton is looking at are provisioning rates or the amount of assets that the banks keep aside to pay for anticipated future losses, slowing growth which he sees as a risk, and net interest income normalization. He is here today to talk about his thoughts.

Eric, thanks so much for being here today.

Eric Compton: Thanks for having me.

Expect to See Higher Provisioning Rates This Quarter

Saldanha: So, let's start by talking about provisioning. Last quarter, the banks saw a drag because of the higher provisioning rates. What are you expecting this quarter? And do you think there's any bank that might have a higher rate than the others?

Compton: So, this quarter, I would not be surprised if provisioning continues to trend a bit higher. It's always tough to predict quarter-to-quarter. It could be a pretty volatile line item. But on average, I wouldn't be surprised if it goes even a little bit higher next quarter. And the reason for that is basically the interest rate backdrop. So, the Bank of Canada has held steady on rates for its last couple of meetings, but longer-term bond yields are still generally climbing. And it takes some time for these higher rates to feed through into the economy, particularly something like the mortgage market where the average mortgage only resets every five years. So, every quarter that goes by, I would expect the interest rate burden in the Canadian economy to keep ratcheting up. In monetary policy, it's what they call long lags. So, I think that's exactly what's going to be playing out. Interest rate burden keeps ratcheting up. And so, that means that the financial situation for the Canadian consumer and also Canadian businesses I think will get a little bit more difficult each quarter going forward as long as rates stay where they are. And so, I think the banks are going to have to provision for that. So, I think at minimum stable to potentially up from here for provisioning.

Which Bank Might Have the Highest Provisioning Rate?

And of any banks to keep an eye on – CIBC (CM) set out the most last quarter. They had a more difficult quarter. They had higher provisioning in one group mostly concentrated in their U.S. commercial real estate portfolio and also related to some assumption changes within their models. So, I think they're really going to be under the microscope to kind of prove that that was more of a one quarter type of deal and that credit isn't actually trending in a way that's greater to Tier ratio compared to peers. So, I would be keeping an eye on that in this upcoming quarter.

Net Interest Income Has Not Yet Bottomed Out for Canadian Banks

Saldanha: Despite this, you expect net interest income to be more normalized. Tell us about that.

Compton: So, net interest income has been an interesting story. So, it's been under increasing pressure, particularly in the U.S. And so, typically, especially in the U.S., as rates go up, especially if they're going up from zero, that's typically a benefit for the banking system. However, once rates start to get, you could call it maybe too high from the bank's perspective, it actually turns into the reverse, turns into a net negative for net interest margins and net interest income. And we're seeing that more in the U.S. banks and more in the U.S. segments of the Canadian banks, but we're seeing something similar also in the Canadian side of the Canadian banks. So, we're in this position where we haven't quite reached an equilibrium. Net interest income perhaps hasn't quite bottomed out for a lot of these banks. And so, we're just waiting for where does that bottom hit, where does net interest income normalize at in this higher rate environment? And so, we're still waiting for that to fully play out. But I do think you start to see a few of the Canadian banks maybe bottom out even this quarter and the next, maybe a few more take one to two more quarters. And so, essentially, I think we're right before the bottom for a lot of these guys. We're waiting for that to officially play out. But on the whole, net interest income has kind of been not the same revenue driver that it has historically been.

Expect Slow Growth in Canadian Bank Balance Sheets

Saldanha: You're worried about slowing growth in Canadian banks. Why is that?

Compton: So, anytime the macroeconomic situation gets more difficult, anytime there's more credit risk, banks get a little more cautious on the lending side. They get a little more cautious on balance sheet growth. And so, that's exactly what we're seeing in Canada. And I expect that trend to continue. Frankly, we've been a little bit surprised that how much more mortgage loan growth was still out there. But I'd expect that to continue to slow for the next couple of quarters. And it really just comes down to higher interest rates means a higher interest rate burden in the economy. And so, all else equal, the economy should be able to afford less debt growth. Like you got to pay more in interest, so you can't keep levering up. And so, I think that's exactly what's going to be playing out in the Canadian economy. And that's why these Canadian banks are going to have to slow down balance sheet growth.

Top Canadian Bank Stock Pick Right Now

Saldanha: And right now, what's at your banking stock pick?

Compton: So, we don't see any of them as too expensive these days. I think previously we had a harder time finding value in these names. But now that they have lagged a little bit, valuations are starting to look a little more interesting from our perspective. We think the trio of CIBC (CM), BMO (BMO) and Scotiabank (BNS) are the cheapest. Each has their own issues at play. Scotiabank has that new CEO. They're in a bit of a turnaround restructuring mode. CIBC has the largest exposure to the Canadian real estate market. And they don't have the best history of risk management. So, I think some people are a little leery of them right now. And BMO, we think, is probably in the best position of the three, but they still have some decently sized exposure to Canadian real estate. So, of the three, I would lean more towards BMO in this environment. It's not in a turnaround mode. There's not like as much restructuring, you could say. But you still have to keep an eye on credit strain. But of the three, I would favor BMO in this environment. Of course, RBC (RY) remains the highest-quality name, but I just don't think it's quite as cheap.

Saldanha: Great. Thank you so much for joining us today with your perspectives, Eric.

Compton: Thanks for having me.

Saldanha: For Morningstar, I'm Ruth Saldanha.