Is there a dark side to Canadian bank outperformance?

Is there a dark side to Canadian bank outperformance?

Is there a dark side to Canadian bank outperformance? Despite recent headwinds such as the collapse in oil prices, low interest rates, and credit quality concerns, Canada’s biggest banks have managed to maintain their stride, often managing better-than-expected dividends for shareholders.

However, a recent article on BNN cites arguments from analysts suggesting that there’s a hidden weakness behind the seeming resilience of the lenders.

“Year-to-date, the Canadian banks are up 10 per cent, outperforming the S&P/TSX Financials by roughly 500 bps,” Barclays analyst John Aiken wrote in a report to clients. “We believe the banks’ strong valuation run has not been necessarily driven by fundamentals.”

Bank stocks have been defying the gravity of recent Canadian GDP numbers, with the Fort McMurray wildfires causing a 0.6% contraction in May. Aiken argues that recent gains are due to more immediate favorable circumstances: recovering oil prices, diminished short interests, the appeal of Canada as a ‘relative safe haven’, and investors’ appetite for yield in a low-interest-rate environment.

“For the latter part of 2015 and early 2016, the bank valuation multiples tracked the downward (and one upward) revision to 2016 GDP growth expectations by the Bank of Canada,” observed Aiken. “However, with the most recent downward revision, valuations broke rank and improved, even as the outlooks for 2016 and 2017 were reduced once again.”

The banks’ surge may have been driven by dividend yields, but economic factors should not be ignored.

“[T]his fixation on yield ignores the fact that the banks’ valuations are moving away from previously highly correlated factors (energy prices and the steepness of the yield curve),” asserted Aiken, “and, more importantly, deteriorating expectations for the Canadian economy as a whole.”

Aiken advised investors that they will have to wait for some time before any of the banks sweeten their payouts, predicting a dearth in dividend hikes until next year.

This view is reinforced by CIBC Capital Markets analyst Robert Sedran. In a report titled No More Gold Stars for Operating Leverage, But ..., Sedran advocated for a long-term perspective from banks that goes beyond meeting quarterly expectations.

“Much as management would like to take a long-term view on organizational design, heaven help the bank that misses consensus by a few pennies owing to higher than forecast investment spending,” remarked Sedran. “Management will have to take a long-term view and worry less about quarterly reporting.”

The big banks are preparing to release their third-quarter earnings reports. Bank of Montreal starts off with a Tuesday announcement, with Royal Bank following on Wednesday, and then CIBC and TD on Thursday. Scotiabank will have its report out on August 30.


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