Are Big Six banks following a two-stage recovery?

Financial sector-focused fund firm argues Q4 sector results support normalization narrative

Are Big Six banks following a two-stage recovery?

It’s been far from a perfect quarter for the Big Six banks, but there have been enough positives in Q4 to support a near-term bullish perspective on Canada’s financial sector.

In a recent blog post, Hamilton ETFs called back to a late-October note it published predicting an accelerated return to normalization in two stages:

  • Banks would prepare for defaults looming in 2021 by building reserves against performing loans up to roughly $25 billion; and
  • They would pull forward expenses, possibly in the form of restructuring charges.

“We were directionally correct on both forecasts,” the firm said. It noted that banks augmented performing allowances by $1.2 billion to reach $24.5 billion going into 2021, and Q4 brought a partial clean-up with three banks reporting messy quarters adding to reserves and/or capital.

Drawing from company reports and data from Barclays, the note said Q4 core earnings among banks reached roughly $11.3 billion, or around 90% of pre-cycle levels. Total provisions for credit losses, meanwhile, declined from $6.77 billion in Q3 to $3.3 billion in Q4.

“The earnings quality was much higher than in Q3,” the firm added, noting that market-sensitive revenues and trading – which it said acted as counter-cyclical buffers against currently prevailing macro risks – both reverted to more “normal” levels. Capital markets-related revenues went from $8.25 billion to $6.78 billion, while trading revenues went from $5 billion to $3.66 billion.

Hamilton ETFs reiterated a November view that banks had entered the recovery phase of the cycle, putting them on the path to begin 2021 with reserves or allowances against performing loans materially above what they would need to withstand a broadly expected increase in defaults next year as federal aid and debt-deferral programs go offline.

As the first part of a two-stage recovery in the credit cycle, the firm predicted that banks would likely be back to pre-cycle profitability by Q1 2021, laying the path for a return to dividend increases. As of Q3, performing reserves already exceeded $23 billion, which the note said could allow banks to endure an increase in defaults without letting it affect their earnings.

By late 2021 or early 2022, the note said banks would start unleashing as much as $6 billion to $8 billion in reserves, mostly from the performing bucket. The consequent large increase in capital ratios, it argued, would support positive market sentiment on the expected comeback of buybacks leads to higher EPS estimates, along with possibly modest P/E expansion coming from accretions from capital deployment and perceptions of stronger balance sheets.

“In our view, the Q4 results validated our forecast of a full recovery of earnings earlier in 2021, accompanied by higher forward estimates and stock prices,” the firm said.


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