Denis Ouellet's  Instablog

Prices are as of March 9, 2012.

North American banks market caps surged 18.5% since the beginning of 2012 with U.S. banks gaining a spectacular 24% while Canadian banks gained only 6.9%.

BAC's 45% stock price advance combined with a 4.5% increase in shares o/s to give the bank a 51% jump in market cap in 9 weeks!

Meanwhile, collective book values of U.S. banks rose only 3.3%. BAC's book value per share declined 3.4% during the period. The 6 Canadian banks are trading at an average P/BV of 2.0x (1.8x last December) compared with 0.9x (0.8x) for the 11 U.S. banks. Four U.S. banks trade at less than 50% of their book value. Only BAC now trades below 0.5x BV.

The Canadian banks are selling at 2.6x tangible BV (2.3x) while the U.S. banks are selling at 1.2x TBV (1.1x). In effect, the TBV of Canadian banks represents 77% of their BV compared with 72% for the U.S. banks.

All 6 Canadian banks earn a ROE (2012e) of more than 15% with an average of 18.5%,up from (18.0% in December). The U.S. banks' average ROE is 9.7%, up from 8.9%.

The price of growth:

Canadian banks' P/BV is 2.2x that of the U.S. banks but their average ROE is 1.9x that of the U.S. banks. Canadian banks' valuation is thus not much out of line when ROE is considered. Alternatively, U.S. banks are not all that cheap when their profitability is considered.

Note the two big outliers STI and CM.

For Canadian banks, investors are paying 0.11 units of BV for each 1% of ROE. For the U.S. banks, that ratio is 0.09, a 14% discount (16% last December). In March 2010, the ratios were 0.11 and 0.14 respectively, the U.S. banks then trading at a 27%premium. In March 2010, U.S. banks' average estimated ROE was 4.9% for 2010 while Canadian banks' estimated average ROE was 17.1%. U.S. banks outlook for 2012 is for ROE averaging 9.7%, 52% that of Canadian banks.

Disclosure: I am long RY, CM, TD, BMO.

The reality is that U.S. consumers are making crude choices. They also have been lucky on the weather!

• they are curbing spending on food: real expenditures on food, though volatile, are unchanged in the past 14 months;
• they have significantly reduced spending on energy goods and services: consumption of energy goods and services have declined 11% since mid-2010, including a near 7% slide in the 3 months to January 2012. To illustrate the mild winter Americans have enjoyed, heating degree days for the Contiguous U.S. declined a huge 17.6% YoY for the 3 months to January 2012. January hdd decreased 20%.

This has freed some income for discretionary expenditures. Real expenditures on goods and services other than food and energy have been climbing steadily since September 2011. In the 5 months to January 2012, PCE ex-food, ex-energy have grown at a 3.3% annualized rate, not spectacular but decent in the current context.

Importantly, as it reflects both pent-up demand and a willingness to fulfill it, real expenditures on durable goods have grown nicely since the summer 2011 lull. In the last 3 months, real spending on durables has risen at a 7.7% annualized rate.

Employment is recovering, boosting employment income while government stimulus is waning. Since mid-2011, growth in transfer payments has stopped while growth in employment income has picked up. Discretionary spending is more likely from employment income than from transfer payments.

Employment growth has been accelerating recently:

That said, one big offsetting item to rising employment income is rising income taxes. The average tax rate has risen steadily in the past year, accelerating in recent months. Personal tax outlays have grown at a 12% annualized rate since October.

As a result, after-tax income growth has declined to the 3% range while spending growth is a shade below 4%, an unstable situation and a precarious one as gasoline prices, hence inflation, are rising rapidly.

The following two charts highlight the challenge for employment income: weekly earnings growth is slowing because wage growth has slowed from the 2.0% range to less than 1.9% YoY.

Let's run simplistic mathematics from here:

• employment growth at +250k per month = +1.5-2.0% YoY.
• wage growth: +1.5-2.0%
• = employment income growth: +3.0-4.0%
• Assume taxes and savings remain flattish: PCE: +3.0-4.0%, much slower than the recent 4.0-5.0% trend but more in line with PDI growth.

What about inflation?

The PCE deflator has been decelerating from +2.9% YoY last September to +2.4% in January. That happened while core PCE was accelerating from +1.6% last September to +1.9% in January.

Energy inflation has declined sharply from +20.7% to +6.5% during the same period as gas prices troughed in December, dropping from their April 2011 peak of nearly $4.00/gal. to their Dec. 20 low of $3.22/gal. On a YoY basis, gas prices are up 6% currently but given their early May peak last year, the crunch on a yearly basis is going to hit in late summer and fall unless oil prices retreat seriously from here. If Brent prices remain near the $120 mark, gas prices will reach $4.25 this summer, +15-20% YoY.

It thus seems unlikely that the PCE deflator will slow much from the current 2.0-3.0% range over the shorter term, leaving little room for a significant acceleration in real spending. As the positive effect of the very mild winter ends, consumer spending is set to display YoY growth rates in the 1-2% range and thus act as a drag on economic growth.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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