Canadian banks are set to report second-quarter earnings later this month, and investors are waiting to see how bad the fallout will be from the pandemic.
“A lot has happened over the quarter, resulting in a wide dispersion of estimates heading into the quarter,” said Natalie Taylor, a portfolio manager at CIBC Asset Management, in an April 23 interview.
To offer insight on banks’ financials given the economic uncertainty, Taylor considered the latest earnings reported by U.S. banks, which had a March quarter-end.
“The biggest take-away from U.S. bank reporting is the greater-than-expected increase in loan loss provisions, given the deterioration we’ve seen in the economy,” she said.
Five large U.S. banks quintupled their loan loss provisions in the current quarter.
“The Canadian banks’ experience will be similar — and could possibly be more severe,” Taylor said.
Canadian banks, with an April quarter-end, are reporting after an extra month of economic lockdown, during which time consumers may have deferred mortgages or credit payments. Canadian consumers are more stretched than U.S. consumers to begin with, Taylor said. Canadian banks also have relatively more exposure to the hard-hit oil and gas sector.
While U.S. banks benefited from higher trading revenue when markets turned volatile, offsetting some of the potential losses from loans, Canadian banks derive a lower percentage of their earnings from capital markets activity, she said.
Investors are also concerned about the impact of low interest rates on banks’ profitability, as well as liquidity.
“Interest rates have fallen precipitously as central banks have attempted to stimulate the economy,” Taylor said. “This will have a lagged negative impact on banks’ margins and profitability over time.”
Yet, the challenge of greater loan loss provisions trumps interest rates in the current economic environment. During a recession, credit losses tend to have a bigger impact on bank profitability, Taylor said.
The uncertainty regarding the recession’s depth and duration is a challenge for banks in the near term. Taylor forecasted that the recession could last a year.
“Typically in a recession, banks experience a number of quarters of rising provisions for credit losses. Share prices typically remain under pressure until it is clear that provisions have peaked and earnings have troughed, and a recovery follows in short order,” she said. “We believe this process will play out over the next six to 12 months.”
Liquidity is less of a concern.
“While we did see some stress in financial conditions emerge back in March, the Fed and Bank of Canada have since flooded the market with liquidity, which has lowered borrowing costs and improved the functioning of the financial system,” she said.
Also, after the 2008–09 financial crisis, regulators ensured banks had buffers by introducing liquidity requirements and dramatically increasing the quality and quantity of capital that banks must hold.
“These stricter requirements, along with quick and decisive action by central banks, put the banks on solid footing going into this downturn, which will help them absorb losses and attend to liquidity needs of their customers,” Taylor said.
While Taylor expects banks’ earnings to decline in the coming quarters, the banks will likely remain profitable and continue to build capital and pay dividends.
However, “dividend increases and buybacks will be on hold for some time,” she said.
Getting picky with financial picks
Within financials, Taylor’s preferred sub-sector is property and casualty (P&C) insurers.
“This industry has much lower interest-rate sensitivity, limited exposure to credit risk and is currently experiencing improved pricing power, as meaningful industry capacity has been wiped out,” she said.
Examples in the commercial space are Greenwich, Conn.–based W.R. Berkley, a U.S. specialty underwriter with a strong track record, she said, and Toronto-based Fairfax Financial Holdings Ltd., a Canadian specialty insurer and reinsurer.
The near-term outlook is more compelling for personal P&C, Taylor said, because “a significant reduction in miles driven is expected to reduce claims costs materially.”
An example is Toronto-based Intact Financial, given its scale — it’s the largest P&C carrier in Canada — and prospects for growth through industry consolidation, she said.
In the U.S., Mayfield Village, Ohio–based Progressive has “best-in-class underwriting, a low-cost model and prospects for growth,” she said.
Another option within financials is alternative asset managers, particularly Toronto-based Brookfield Asset Management.
The firm has “a defensive tilt,” having purchased a majority stake in distressed credit manager Oaktree Capital Management last year, Taylor said.
Further, Brookfield has “significant” liquidity with recently raised funds it can put to work opportunistically, she said. In February, the firm closed a $20-billion infrastructure fund.
The asset manager’s focus includes real estate, and last week it announced a US$5-billion program to take a non-controlling interest in ailing retailers.
This article is part of the AdvisorToGo program, powered by CIBC. It was written without input from the sponsor.