Canadian banks generally beat earnings, but what risks do they still carry?
Last week’s earnings reports from Canada’s big six banks were yet another broad show of strength. The banks all beat their earnings expectations, on the back of resilience in lending and higher interest income from mortgage renewals, strong capital markets and wealth management businesses, and a longer-term drive to bring down costs per dollar of revenue. The banks’ continued strength has buoyed the sector’s PE multiples, with the average PE for the big six rising to 17.4, well above its historical average of 11.8. The question for advisors is now what to do as bank stocks look strong but expensive.
Sam Baldwin, Senior Portfolio Manager for Canadian Equity at Guardian Capital LP in Toronto, and Sankalp Sachdeva, Portfolio Manager and Partner at Letko Brosseau in Montreal, each offered a slew of insights into where this latest earnings season leaves the banks. Both noted the significant rerating in bank earnings multiples and the importance of non-bank businesses like wealth management to this success. Both also weighed in on the question of whether the banks’ solidity and strong lending safeguards are enough to weather a new tariff storm brewing south of the border.
“What we've seen, over the past couple of years in particular is a monumental rerating. Bank earnings have increased, and they typically increase in the high single digits durably and sustainably. And then every once in a while, they get electrocuted, and then there's a big bounce back. And so the other side of the V is where you would see kind of 20 per cent earnings growth off of a low base,” Baldwin says. “What we've seen in the last couple of years is the combination of bank PE rerating and strong earnings growth, as you've seen a combination of all divisions firing on all cylinders.”
“Asset quality has been stable to improving. Credit costs were as per our expectations. The returns on equity are actually running at their medium-term guidance. So things have been moving in the right direction,” Sachdeva adds.
Could tariffs derail bank growth?
While the banks have been strong over the past several quarters, the sector does carry some wider exposure to the underlying Canadian economy. As that economy has faced uncertainty brought on by US tariff threats, the banks have dug protective moats. They’ve added to loan loss provisions quite substantially in order to safeguard against defaults. At the same time, the banks have raised lending standards and been more restrictive in their lending to protect themselves from possible economic weaknesses brought on by tariffs. The question for investors and advisors, as new tariffs hit the economy, is whether those provisions are enough?
“The banks were proactive to qualify that the sectors facing a new 50% tariff only represent about 1 per cent of the loans that the banks carry, so the exposure is quite manageable,” Sachdeva says. “But, things can escalate.”
Sachdeva notes that the banks have actually lowered some of the loan loss provisions they had banked in earlier quarters, reflecting a degree of growing confidence. TD, for example, has even stated that current loan losses are running at the lower end of their expected range. Sachdeva’s view is that the banks are still well reserved for any economic headwinds.
Baldwin offers a slightly more cautious note, emphasizing the fact that the new tariffs were only manifesting last week, when the banks had all effectively locked in their filings and earnings reports. He expects greater clarity on how these tariffs are impacting the banks in the next quarterly earnings. Still, he highlighted the strong positions of the banks and their likely positions as secondary beneficiaries from fiscal stimulus as reasons for some confidence.
Non-bank drivers of bank performance
Both Baldwin and Sachdeva emphasized how important the banks’ wealth management and capital markets divisions have been for their strong earnings. They highlighted the role of AI adoption and other cost control measures as ways that these institutions are driving costs down relative to their income. Sachdeva notes that in this round of earnings, expense growth was slightly higher than median, but that was taken in line with top-line revenue growth, especially in areas like wealth management where costs rise with revenues.
Capital markets, Sachdeva says, has done very well given the sector’s generally high degree of success during period of volatility. More deals being done drives strength for the banks, which Sachdeva says sets higher expectations for next quarter, adding a potential risk to future performance. Wealth management has also done well on strong equity market performance but carries a degree of risk associated with a potential correction in those markets.
Despite the way these business lines have contributed to earnings growth at the banks, Baldwin stresses that they should still be viewed as banks first and financial conglomerates second. Within Canada, their banking business drives huge returns on equity (ROE) and while these other businesses can add value for the banks, the core of the business rests on traditional banking. As it stands those bank businesses are doing well just as non-bank lines of business add additional value. For advisors looking at the banks now, the question is whether an investment into a set of companies in such a strong position makes sense.
“The historical pattern is that people feel very comfortable with the investments that are doing well, but it doesn't necessarily mean that that's where your marginal dollars should go. Because if everything's hunky-dory and you're trading on an elevated multiple and there's no danger on the horizon, you're probably not looking at a coiled spring that's gonna explode upwards,” says Baldwin. “Most people in Canada own the banks. They own them from a very low cost base. They've done really well with them. They typically hang on tight in those situations. But, even just within the Canadian equity market, there's a lot of other investment opportunities that are much more compelling than the banks. Even though the banks have done well, even partly because the banks have done so well.”
