Capital markets businesses weakened at the end of Canadian banks’ fiscal Q1, and investors hoping for a rebound in this quarter’s earnings will be disappointed, says Stephen Carlin, managing director and global head of equities at CIBC Asset Management.
Carlin expects “tepid performance” from banks when they announce their second-quarter earnings later this month. CIBC will be the first of the big six to report on May 22, and National Bank will close the earnings season on May 30.
“We’re expecting the banks on the capital markets side of the business to report better than Q1, but not what investors may have been expecting for Q2,” Carlin said in an April 11 interview.
Central banks holding interest rates will further add to the flat or “mildly negative” environment.
“When I say mildly negative, we’re talking basis points,” said Carlin, whose firm offers funds such as the CIBC Canadian Equity Fund. “So not really enough to move the needle. Where we thought we might’ve had a little bit of a tailwind, the interest-rate environment has turned into something that’s not helping earnings at all.”
The good news, he said, is that some of the “softness” from the capital market side is “baked in” to current valuations.
Further, loan growth should be positive.
“Commercial loan growth continues to truck along in that low- to high-single-digit growth range,” he said. “Commercial real estate is going to be good.”
However, loan growth on the consumer side “will be pressured,” he said, due to a softer real estate market and “tepid” mortgage growth.
“As we look at all of that, we still think that banks can exhibit loan growth.”
And with markets recovering strongly this year, Carlin predicted that fee income for banks would rise, especially from asset management businesses.
U.S. hedge funds negative on banks
Throughout the year, there have been reports of U.S. hedge funds shorting Canadian banks—including Steve Eisman, portfolio manager at Neuberger Berman and one of the central characters in the book and film The Big Short.
Carlin said the hedge funds alleged Canadian banks had “manufactured their earnings by reversing credit provisions during the year.”
“Our fundamental research has suggested [this] is fatally flawed. A number of banks were actually increasing the provisions on credit during 2018, which was actually a headwind, meaning it was a negative impact on earnings.”
He added, “[We] believe strongly in the way that we analyze the businesses. So from that perspective, we believe those assumptions are incorrect, and that creates market opportunity.”
Carlin also said hedge funds alleged the “banks have been artificially raising their capital ratios by underweighting their risk weightings for real estate exposure.”
However, Canada’s policy environment is stricter in terms of underwriting standards, he explained.
“When you look at the loan-to-value of the banks’ mortgage portfolios, the loans outstanding relative to the value of the properties that they’re underwriting is currently at 55%, which is very conservative,” he said. “[This means] the banks have very significant cushion in their underwriting standards relative to any potential shrinkage in the value of real estate.”
Investors shouldn’t apply assumptions they might use for U.S. companies or U.S. banks to the Canadian market, he said.
Overall, Carlin said, “Canadian banks—from both a positioning perspective and an underwriting perspective—are in much better shape than implied by some of those reports.”
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