How a Slowdown Affects Canadian Financials

Text transcript

Natalie Taylor, portfolio manager at CIBC Asset Management.

After two years of strong earnings growth, the Canadian banks did report a bit of a softer quarter in Q2 earnings down year over year, and generally coming in short of consensus.

So the earnings shortfall was driven by greater pressure on margin as well as higher expenses, which were up on average about 11%, and that’s due to the higher inflationary environment that we’re currently experiencing. Credit costs did increase or normalize as well, but for the remainder of the year, Canadian banks’ earnings are expected to continue to modestly decline, driven by more of the same, so some margin contraction, slowing loan growth, and higher credit costs. So items that are consistent with an economic slowdown.

Share prices are already discounting a stalling of earnings growth in 2023. However, I would say there’s a number of wild cards that could impact the earnings forecast from here in the near term.

So first, is the trajectory of expenses and whether management teams become more aggressive in managing these expenses.

Second, is the potential growth uplift from rising immigration to Canada and the impact to the Canadian economy as well as to the banks directly in the form of new customers.

And then lastly, I would say the Bank of Canada surprised us in June with a 25 basis point hike, while the market was expecting a pause similar to what the Fed opted to do. The Bank of Canada continues to be a little bit more hawkish than the market expects. The chance of a policy error or the perception of a policy error increases, and the odds of a recession also continue to increase.

While a slowdown in economic growth is reflected in current earnings estimates for the Canadian banks, I would say that a recession is not. A potential recession has been widely discussed and is expected. However, it’s difficult to forecast a timing or magnitude with any accuracy.

So for the banks, the biggest source of earnings variability in a recession is an increase in their credit costs, which can jump as much as two to three times the current or what’s considered normal levels. So for example, provisions for credit losses are 20 to 30 basis points of loans currently, and it’s not unusual for them to increase to 70 to 80 basis points of loans at the peak of a cycle.

So when a recession starts, investors and analysts often have very little visibility into the source and severity of these credit losses, and when they’ll peak. As such, the early part of an economic downturn, when job losses start being reported, can result in a negative overshoot in bank valuations. We also tend to see net interest margin contraction alongside rate cuts, which are typically enacted to get the economy going again. And we typically see a meaningful slowdown in capital markets activity as well.

I know there’s no such thing as a typical recession, but previous downturns have resulted in about a 15% to 20% decline in bank earnings on average, versus what’s currently embedded in consensus, which is a mid-single digit decline.

On rare occasions, if a bank is undercapitalized or is faced with outsized credit costs, valuation multiples can come under more severe stress, and/or remain impaired for some time. However, typically earnings tend to recover within a 12-to-24-month period. Once there’s some visibility on credit costs peaking and valuations typically follow suit.

So it’s worth mentioning that the Canadian banks have maintained their dividends over the last 30 years, which includes a number of economic corrections in there. And dividend increases have periodically been halted, but dividends have not been cut, and we expect this to be the case again this time around if we are to see a recession as capital levels and the quality of capital have continued to improve over time.

Based on the pattern I just described, the unfolding of a recession in banks’ earnings around that, there’s a risk to bank performance over the next year depending on what your view is of the economy going forward. While banks have a well-earned reputation for being consistent performers, there’s no doubt that they are economically sensitive. Banks with higher capital levels, strong capital generation, potential attractive valuations, healthy dividend yields in that 5% to 6% range, such as a TD Bank or a Royal, remain part of the portfolio. However, currently we believe there are few opportunities in high quality defensive companies with long-term secular growth potential.

So both of these companies have faced near term setbacks, which is creating what we believe is an attractive buying opportunity. The first is Element Fleet Management, which offers financing and services related to corporate fleets. It’s the largest standalone player in a growing and consolidating industry, but recently it’s struggled with vehicle availability due to supply chain challenges, and it’s been unable to satisfy growing order backlogs from strong demand. The log jam seems to be breaking, and growth is showing signs of picking up. In addition, the fleet management industry has historically experienced fairly benign credit losses in a downturn, given the mission-critical nature of the assets and strong counterparties. The business also has limited sensitivity to moves and interest rates.

So over the longer term, we expect Element to grow its high quality service, revenue stream, continue to take market share, penetrate self-managed fleets, and benefit from the transition to electric vehicles.

The second opportunity is Intact Financial. Intact is the largest property and casualty insurer in Canada. Demand for its insurance products is not influenced by the economic backdrop, and in the case of personal auto insurance, Intact’s largest business demand is required by law. So the regulated nature of the industry has been somewhat of a headwind recently, as rate or price increases, which need to be filed with the regulator, have lagged the considerable cost inflation that we’ve seen.

As price increases flow through and cost inflation eases margins are very well positioned to expand from here. Over the longer term, Intact will continue to benefit from its scale, which is a significant advantage in underwriting, and also adds to its ability to continue to consolidate the industry.