Investors beware—Canada’s big banks are in for a rough year

Don’t count on financial stocks to prop up your portfolio the way they once did

Illustration of a run-down looking bank

(Illustration by Serge Bloch)

If you’re a Canadian investor, chances are you own the stock of at least one Canadian bank. The Big Five have a reputation for being the most basic, common-sense investments you can make. But this is the first year since the onset of the recession that there’s reason for pessimism around the Canadian banks. Growth in consumer lending is slowing, the oilpatch is hurting, and the Bank of Canada surprised markets with a rate cut in January, putting more pressure on their profit margins. Shareholders will have to contend with smaller returns this year. And while investors sometimes treat the sector as a monolith, distinguishing between companies is increasingly important.

To be clear, the banks aren’t facing collapse. But instead of an earnings per share growth of 10% year after year, bank earnings will grow more like 5% for the foreseeable future. The main reason is the slowdown in consumer lending. Household debt is still at record highs, and Canadians may finally be listening to the warnings from the Bank of Canada and others to curtail what they take on. For the year ended Oct. 31, 2014, loan growth totalled just under 5%; in recent years, it’s run between 8% and 10%.

The central bank’s interest rate cut won’t be of much help to commercial lenders. A quarter-point cut is unlikely to entice overstretched consumers to borrow more, says John Aiken, an analyst at Barclays Capital. Business lending could pick up, but it comprises a smaller part of the banks’ loan portfolios than mortgages and other consumer loans. The banks didn’t even match the Bank of Canada’s quarter-point cut, dropping their prime rates by 0.15%. “They’re trying to defend their net interest margins [the difference between their borrowing costs and lending rates] as much as they can,” Aiken says.

Patrick Kim, a partner at Georgian Capital Partners, isn’t too worried about the effect on the banks just yet. He points out that the cut is positive for equities in general, perhaps prompting more investors to move out of bonds and into stocks. Low rates are actually worse for insurance companies, and investors could shift their funds toward banks as a result. But protecting margins becomes a lot harder for the banks if interest rates go down again—something nine out of 23 economists surveyed by Bloomberg are forecasting for the end of this quarter. “Then you’re definitely going to see some pressure from Ottawa on the banks to see the prime rate lowered, just for the sake of protecting consumer cash flows,” Kim says. 

One way the banks can respond to poorer business conditions is through cost-cutting. Bank of Nova Scotia (TSX: BNS) announced 1,500 layoffs last fall, and Canadian Imperial Bank of Commerce (TSX: CM) made 500 job cuts at the end of January. Toronto-Dominion Bank (TSX: TD) CEO Bharat Masrani also spoke ominously of the need to “increase efficiency and streamline our cost base” in an earnings call in December. Dan Werner, a financial services analyst at Morningstar, wonders if Royal Bank of Canada (TSX: RY) might be next. Capital markets started off strong in 2014 but waned as the year wore on. RBC has a larger capital markets division than its Big Five peers, and it could feel the effects. “It’s hard to maintain the expenses associated with that initial pace, so I would look to RBC for some cost-cutting measures,” Werner says.

Investors might also be able to look forward to share buybacks, according to Brian Klock, an analyst with Keefe, Bruyette and Woods in Boston. “The good thing about having your stock go lower is when you buy it back, it’s more meaningful,” he says. However, the banks are subject to strict capital ratio regulations, which could limit the extent of repurchases.

This year it will pay for investors to be more selective in terms of bank stocks. Aiken says the country’s No. 6 bank, National Bank (TSX: NA), is trading at a slight discount to its historical average, which likely stems from investor concern that it’s a predominantly domestic firm. But it has a couple of things going for it. First, National’s capital markets business accounts for an even larger share of its earnings than RBC’s, and its earnings from that division have defied the larger trends by remaining stable. Second, it has been stealing market share from Desjardins Group in Quebec. “That’s an opportunity that’s not necessarily available to the Big Five,” Aiken says.

Banks that have access beyond Canada’s borders are worth a look, too. Both TD and Bank of Montreal (TSX: BMO) have operations in the United States, where the economy is accelerating at a faster clip. “The Canadian banks have to be somewhere, and the U.S. has more positive momentum than anywhere else in the world,” says Kim. TD is his firm’s only Canadian bank holding, which it prefers over BMO because TD’s American operations are larger. BMO is also focused on the Midwest, which is heavily tied to the struggling manufacturing sector, Werner says, so the upside potential might not be as great as with TD.

Scotiabank used to be favoured because of its extensive operations in Latin America and the Caribbean. Not anymore. “The bank that will have the most difficulty is Scotia,” says Meny Grauman, an analyst at Cormark Securities. Those economies are heavily oil-dependent, more so than Canada, and will suffer as long as the price of crude remains low. “All the Canadian banks have to deal with getting hit once from falling energy prices, but Scotia has to deal with a double whammy,” Grauman says.

As a consolation for bank investors faced with lower returns this year, it pays to remember that the country’s financial institutions have a long history of profitability, and they continued to churn out blockbuster quarters for longer than analysts anticipated. Because if there’s one thing banks are good at, it’s making money. There’s just less of it to go around these days.