Hamilton ETFs says risks to Big Six banks have proven benign, but 'central disagreement' remains
With a backdrop of uncertainty around interest rates, inflation, and possible recession, it’s going to be a big week for Canada’s Big Six banks as Canadian investors watch for hints of strength or weakness in the vaunted financial subsector.
CIBC kicked off the first bank earnings parade for 2023 last Friday by handily beating profit estimates. As per Refinitiv data, its overall revenue rose 8% to $5.93 billion, while it earned $1.94 per share on an adjusted basis, easily above expectations of $1.70.
Commenting on CIBC’s results, Robert Wessel, managing partner and co-founder at Hamilton ETFs, says the bank’s credit division also performed better than expected, though he noted that analysts have been quite conservative on that front. Its capital markets unit has also surprised to the upside after shown some weakness over the past couple quarters.
“These two items are highly material to bank profitability,” he says. “It’s only one bank, but that gives some room for optimism on the broader sector.”
Another opportunity for Canadian banks, he says, is the potential for net interest margin expansion. Last year’s extreme rising-rate environment has provided fuel for a lot of optimism on that front since the banks’ fiscal second quarter last year.
Wessel notes that a lot of the banks reported margin compression during their Q2 earnings calls, prompting investor concerns and causing their share prices to trade off. But in a commentary last month, Hamilton said that compression was caused in part by challenges in the banks’ trading books rather than their lending books, suggesting that the margin profit story remains intact.
“You saw from the CIBC results on Friday that they had margin expansion from lending activities,” he says.
One of two risks Hamilton highlighted in its January note involved rising regulatory risk. The Office of the Superintendent of Financial Institutions’ (OSFI) December decision to increase its domestic stability buffer requirements caught markets off-guard. Following that move, BMO raised $3.15 billion in equity through a share offering.
“For now, it seems the banks are able to keep that risk at bay,” Wessel says.
The other risk has to do with a new accounting protocol, under which banks would be required to set aside allowances for loans that are not performing poorly. That change “has been by far the biggest creator of volatility in this downturn and recovery,” according to Wessel.
This is the first cycle that banks have had to deal with the new accounting treatment. Wessel says the allowances for performing loans have barely moved this quarter, but because the protocol isn’t necessarily related to fundamentals, there’s a risk of that number moving up unexpectedly.
“Looking at all the opportunities and risks taken together, things are looking pretty positive for the sector this quarter. And the sector is very cheap,” he says. “The banks rallied in January, but that was after banks absorbed the correction last year that brought them down to depressed levels.”
Based on the S&P/TSX Diversified Bank Total Return Index, Hamilton’s January note said Canadian banks fell 8.9% in 2022, representing just its fifth decline in the last 20 years including the 2007-2008 financial crisis. In a previous note from Q4, the firm said banks were trading at deeply discounted valuations, implying reductions of at least 15% in analyst estimates.
The outlook for recession – how it could play out, if it does, and how it would flow through to the sector – is a major question mark hanging over banks. From Wessel’s vantage point, analysts have been persistently optimistic on banks’ earnings compared to the market.
“There’s this central disagreement. Last quarter, the market stayed pessimistic, and analysts held firm on their forward estimates. … Analysts’ forecasts for provisions would suggest something in between a soft landing and a hard landing,” he says. “If we get a soft landing, their estimates are going to go quite a bit higher and the sector will do well. If there’s a hard landing, I guess we’ll see.”