Investors set to benefit from Canadian banks’ bounceback

Canadian banks beat earnings expectations in their second quarter, and the positive performance could persist as the post-pandemic economy picks up.

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“We’re seeing the type of momentum from the banks that you would expect during an economic recovery,” said Natalie Taylor, a portfolio manager with CIBC Asset Management. “We think they’re well positioned to benefit from continued recovery and economic expansion.”

Second-quarter bank earnings beat expectations by a “meaningful” 8% to 18%, Taylor said, with the primary driver being continued improvement in credit costs, including the reversal of record-level loan-loss reserves.

“Provisions for credit losses appear to have peaked in the third quarter of 2020 and have been declining since then,” Taylor said.

Another earnings driver in the quarter was capital markets, which had earnings at nearly double the level of the same quarter a year prior when activity was at extremely low levels.

“Capital markets has been a strong source of earnings for over a year now,” said Taylor, who manages the CIBC Dividend Income Fund. “It’s not often viewed as a sustainable source of long-term earnings growth, but the segment does continue to surprise to the upside.”

Other positive signs in the quarter were banks’ net interest margins, which are showing signs of stabilization; strong loan growth in mortgages; and positive operating leverage, Taylor said.

“Overall, we saw some very favourable results from the banking sector, and that was reflected in the share price moves we saw.”

Looking ahead, Taylor foresees more upside from the banks during recovery, with potential for them to return increasing amounts of capital to shareholders — potentially as early as next quarter, she said.

When the pandemic began, the Office of the Superintendent of Financial Institutions placed restrictions on banks, including freezing dividend increases and share buybacks. Lifting those restrictions is dependent on an end to lockdowns, the banking regulator has said.

“Given the progress that we’ve made in terms of vaccinations, it’s reasonable to think that we’re getting closer to that point in time where banks can return capital,” Taylor said.

As a result of the restrictions, banks have accrued significant capital, especially TD and BMO, she said. “We estimate that on average the banks can increase dividends by 25% and buy back 5% of shares and still remain over an 11% capital ratio, which is still a robust capital level.”

Deployment of capital could also be used in mergers and acquisitions, she added, creating growth opportunities. TD chief executive Bharat Masrani, for example, recently told analysts that the bank is prepared to make deals.

Upside may also come from higher short-term rates, which isn’t priced in yet, Taylor said.

While the Bank of Canada may not raise interest rates until later this year and the Federal Reserve may hold off substantially longer, rate hikes could start to get priced in over the next year, she said, and “rate hikes can add quite meaningfully to earnings, as we saw in the last rate hike cycle around 2018.”

Based on banks’ disclosure of their sensitivities to a 100-basis-point interest rate increase, “TD would be best positioned and we could see 7% earnings growth from higher rates,” Taylor said, “while the remaining banks would be more in the 5% range.”

While bank earnings and valuations have recovered meaningfully over the last year, “we do think there’s more upside driven by continued economic recovery,” she said.

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