Low Rates And Strong Equity Markets To Boost Canadian Bank Shares

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Includes: BMO, BNS, CBWBF, CM, LRCDF, NTIOF, RY, TD
by: Livio Filice

Summary

Stubbornly Low Interest Rates Create A Fundamental Strong Platform.

Strong Equity Markets Raise Assets Under Management.

Credit Suisse Bumps Outlook for Bank Shares; More room for growth.

Canadian banks have historically been characterized as paying consistent, moderate, and growing dividends with a steadily increasing share price backed by predictable strong earnings. The "Big 5" Canadian banks include Royal Bank of Canada (NYSE:RY), Toronto-Dominion Bank (NYSE:TD), The Bank of Nova Scotia (NYSE:BNS), Bank of Montreal (NYSE:BMO) and Canadian Imperial Bank of Commerce (NYSE:CM). The second or smaller-tier banks include companies such as National Bank of Canada (OTCPK:NTIOF), Canadian Western Bank (OTCPK:CBWBF) and Laurentian Bank of Canada (OTCPK:LRCDF). Globally, the Canadian banking industry is widely accepted to be one of the safest banking networks in the world, partly because of the industries oligopolistic structure, barriers to market entry and government backing.

Bank shareholders have recently witnessed a strong incline in share prices which has been driven by a couple of different factors related to the macro economy. The strengthening share prices have moved bank shares from income-generating investments to growth stories. Toronto-Dominion Bank, which is more commonly referred to as TD Bank, is bearing the fruits of their acquisitions in the U.S., while the Bank of Nova Scotia, or simply ScotiaBank, has been benefiting from over a decade of acquisitions in emerging markets primarily in Asia, Caribbean and South America. While each bank has its own story to tell and some banks are benefiting more than others there are marco factors which are allowing share prices to break through new highs.

Stubbornly Low Interest Rates Create A Fundamental Strong Platform

Low interest rates are having two effects on bank shares. First off, low interest mean that investors of all sizes simply do not want to hold cash. Low interest rates being paid on GIC's, and Savings Accounts are not keeping cash value above inflation rates. Even though inflation rates are significantly low, still fixed investments such as GICs in some cases are not paying more than 1%. Dividend yields in bank shares, although historically low, are still generating 3.4%-4% which is significantly higher than interest paid on saving accounts. Simply put cash is losing value and investors are looking to deploy capital.

Secondly, the historically low inflation rate is a clear indication that the thought of a serious economic crisis or challenge has evaporated, although this could change in the next years. The Central Bank of Canada, along with numerous other Central Banks, have not seen any firm justification to hike interest rates as the economy still has a lot of room for growth. Another fear is that heavily indebted Canadians would be placed in a difficult position should interest rates move higher. Further, higher interest rates have the ability to delay business spending in new capital while municipalities would also slow spending.

With the Bank of Canada avoiding an increase interest rates for possibly several more years, it is in my opinion that this is a solid indication to the market that we may be in a prolonged time with little economic growth and low inflation. It is without a doubt that the recent rally in income-generating bank shares is heavily related to the fact that central banks have avoided raising key interest rates due to slower economic recovery.

Strong Equity Markets Raise Assets Under Management

U.S. equity markets have rapidly been increasing since late 2012 leading into 2013, which assisted in a rise in Canadian equities in 2013 and 2014. To put this in perspective, the TSX Composite index is trading at an all time high which recently broke over 15,000. It has not traded in this current range since before the 2008 collapse. Although retail and business banking accounts for a large portion of banks profits, investors cannot deny that big upticks in the equity markets will directly bump revenues for the banking industries institutional and wealth management divisions. As the value of equities grows, the amount under wealth management also grows in line with the equities and allows the market to place new valuations on bank shares. As the market stays strong as we head into the latter part of 2014 and into early 2015, investors will be rewarded with stronger revenues in the capital market income, which will ultimately allow analyst to bump ratios for bank shares. This has already started to happen.

Credit Suisse Bumps Outlook for Bank Shares

According to Canadian sources, Credit Suisse analyst, Kevin Choquette, has raised his price targets on all major Canadian banks. Mr. Choquette rates Bank of Nova Scotia "outperform" with a target of at $84. He rates Canadian Imperial Bank of Commerce "neutral, with a new target of $110 and National Bank of Canada "neutral," with a $50 target. Further, he views Royal Bank of Canada "outperform" with a $92 target and Toronto-Dominion Bank "neutral," with a $63 target. Mr. Choquette commented:

We expect superior shareholder returns for the banks to continue, based on steady gradual P/E multiple expansion, high dividend yields, high and sustainable profitability, high capital generation, solid earnings growth despite the low interest rate environment, and slow credit growth as well as significant positive earnings leverage to higher interest rates. We see reasonable earnings growth for the bank group in the 8-per-cent to 10-per-cent range. We believe net interest margins have stabilized.

Where do we go from here?

Based on the indications that I have outlined, in theory, shares in Canadian banks should remain strong and continue to see growth in the next years. The European Central Bank continues to cut interest rates and is presently planning a stimulus package to avoid slipping back into a recession. With the Europeans, Canadians and Americans bumping along, it is my personal opinion that rates will continue to remain low, which will encourage spending, which will benefit the banks, and thus their shareholders.

Further, alternative investments are non-exist. Since the financial recession of 2008 appetite for speculative investments have dried up and demand for solid blue chip stocks has risen. GICs, Saving Accounts, corporate and government bonds are not providing investors with any value. In fact, these investments are net loss year over year when factoring in inflation.

Analysts continue to upgrade the banking industry, dividends remain strong and as earnings continue to remain the same or increase there is no reason to pull out of Canadian banks. I remain strong and bullish on Canadian banks and intend to increase my position on any possible market pullback.

Disclosure: The author is long TD, BNS, CM, NTIOF.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.