In light of Canadian banks' earnings, I think it is necessary for investors to revisit their thesis and adjust their expectations given the higher energy provisions and uncertainties involving the Canadian housing outlook. Overall, earnings were subdued with growth coming in at +3% on higher energy provision, but international and FX certainly helped banks such as TD (NYSE:TD) and BNS (NYSE:BNS). Canadian P&C appears to be resilient while capital market is relatively strong despite the weak energy tape. However, I see material downside risk to the group in the coming quarters driven by uncertainties involved with Canadian housing, structural shift towards digital banking, and worsening credit due to the energy exposure. I would underweight the sector in the next twelve months and stick with the two preferred picks within the group, namely TD and Royal (NYSE:RY), which I see to have better domestic positioning relative to peers, better global exposure, and better capital market business.
When looking at the group, earnings were mostly driven by international, with growth with FX contribution having the biggest impact on TD at 2.5%, followed by BNS at 2%. TD's exposure to the US is certainly a positive, with the bank gaining shares at the regional level, while TD Ameritrade continues to perform within expectations. BNS also did well, although I caution that the stock has had a great run year to date, and valuation is starting to be on par to that of the peers, so I would not add more at this level.
As for domestic banking, earnings for the group were up a modest 6% in an already challenging environment due to higher PCLs (+13% y/y) from energy exposure. PCLs were up 74% y/y, accounting for 46bps of the loans with energy PCLs accounting for 26% of the total. Consensus appears to expect 50bps to be the quarterly peak, but I believe that it seems to be overly optimistic. Although management remains positive at the credit outlook and that overall credit exposure will be contained in the energy sector, I want to note that a small, contained credit cycle is rare in the past forty years as PCLs have surpassed 50-60bps historically.
Housing is another area that could provide to be troublesome with real estate price in both Toronto and Vancouver making headlines. Although I do not expect a dramatic correction in the near term due to the amount of hot money from new immigrants supporting real estate pockets in greater Toronto and Vancouver, I do expect deceleration in housing sales and activities due to the growing regulatory risk and the increasing calls from the banks on regulators to control housing.
While I acknowledge that the call for Toronto housing bubble has been around for the past five years, I believe this time is different as both the banks and the regulators appear to be committed on controlling the hot housing market. Several methods are at the banks'/regulators' disposal including increasing down payment from the current 5% to a minimum 10%, establishing a luxury tax on foreign speculators, a tougher quality rates for buyers, and a property surtax for buyers. All these methods can be utilized by the regulators to cool the housing market, and it appears that the regulators are taking a keener focus on this issue, whereas before they allowed the market to determine the price.
Finally, threats from fintech cannot be underestimated. Looking at the existing fintech services, it is apparent that the conventional banks will face pressure from digital rivals. Although all the banks are creating their own digital/fintech segment to counter the threat, I note that the bureaucracy within the banks simply cannot allow innovation to foster in a way similar to that of a tech culture. Amongst the businesses that will be impacted by fintech include mortgages due to the rise of P2P lending, payment due to the rise of third-party platforms such as PayPal (NASDAQ:PYPL) and Apple Pay (NASDAQ:AAPL), wealth management due to robo-advisory, and fintech wealth management (i.e. Wealth Simple) and insurance (online insurance recommendation engine). To be clear, I am not calling RY or TD to go out of business because borrowers are turning to LendingClub (NYSE:LC), but I am calling that fintech is an inherent risk that investors cannot ignore.
That said, I am underweight on the Canadian banks and prefer TD and RY over the other banks. (see - TD Bank: Well Positioned For Ex-Canada Growth and Royal Bank Of Canada: Downgrade From S&P - Buy On Weakness). Also note that I would underweight BNS due to valuation, underweight BMO (NYSE:BMO) and CIBC (NYSE:CM) due their over-exposure to the domestic market.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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