Big Five to benefit from U.S. tax reform, higher interest rates

The forecast for Canada’s biggest banks is bright thanks to U.S. tax reform and higher interest rates, but as they report first-quarter results this week, domestic mortgage demand and the North American Free Trade Agreement could cloud the long-term outlook, analysts say.

Earnings estimates for the 2018 fiscal year are being revised upwards by some analysts to account for the impending bump from recent interest rate hikes and a U.S. corporate tax cut from 35% to 21% that took effect on Jan. 1.

CIBC World Markets analyst Robert Sedran lifted the assumed average growth rate for the sector in fiscal 2018 from 7% to 9%, “turning what was already expected to be a good year into a better one.”

However, analysts say the impact of stricter rules surrounding uninsured mortgages as of Jan. 1 and tumultuous NAFTA negotiations will weigh on the Big Five banks.

“We believe short-term gains could fade shortly after earnings season as ‘the usual’ sector overhangs weigh on H1/18 performance, namely the housing market and NAFTA,” National Bank of Canada Financial Markets analyst Gabriel Dechaine told clients in a research note. “In other words: be nimble.”

Read: Here’s how portfolio managers are investing now

The Canadian Imperial Bank of Commerce starts off the latest round of earnings for the quarter ended Jan. 31 on Thursday, followed by Royal Bank of Canada on Friday. The Bank of Montreal and the Bank of Nova Scotia both report their fiscal first-quarter earnings on Feb. 27, while Toronto-Dominion Bank reports its earnings on March 1.

Last quarter, Canada’s five biggest banks earned more than $10 billion in collective profits on the surprising strength of the domestic economy. For fiscal 2017 as a whole, each of the five biggest Canadian lenders reported record annual profits for a collective total of $40.3 billion in net income, up nearly 13% from a year earlier.

“While Canada’s GDP is expected to ebb, we maintain that the broad-based strength suggests that the economic growth will continue to stay in positive territory, and by extension, bode well for the banks’ operating environment,” said John Aiken, an analyst with Barclays in Toronto, in a note to clients.

Mortgage rules could present headwind

However, Canadian lenders have cautioned that tougher mortgage rules introduced by the federal financial services regulator could present a headwind to its loan originations, ranging between 5% and 10%.

As of Jan. 1, in order to get a loan from a federally regulated lender, homebuyers have to prove they can service their uninsured mortgages at a qualifying rate of the greater of the contractual mortgage rate plus two percentage points or the five-year benchmark rate published by the Bank of Canada. An existing stress test already requires those with insured mortgages to qualify at the Bank of Canada benchmark five-year mortgage rate.

Some mortgage brokers have said that the borrower rejection rate from large banks and traditional monoline lenders has risen as much as 20% as a result, as they increasingly direct clients toward alternative lenders and credit unions, which are not subject to the new rules.

Meanwhile, demand for mortgages in December saw an uptick, with national sales up 4.5% according to the Canadian Real Estate Association, as buyers scrambled to snap up homes before Jan. 1.

And while the fate of NAFTA remains uncertain, President Donald Trump’s tax overhaul is expected to provide a significant earnings lift in the future for Canadian lenders with exposure south of the border.

First-quarter results, however, will be impacted by one-time writedowns as the banks reduce the value net deferred tax assets already held on company balance sheets.

BMO has said it expects to reduce its deferred tax assets by US$400 million, while RBC has said it is expecting a roughly $150-million charge. TD said it expects its first-quarter results to be cut by roughly US$400 million, and CIBC has signalled a $100-million writedown. Scotiabank, whose expansion strategy has a larger focus on Latin America than its peers, has said it is expecting a charge of roughly $5 million to $10 million.

Read: Sun Life Financial predicts impact of U.S. tax changes

“We expect any write-downs to be more than fully offset by new tax savings as well as strong organic capital generation,” said Sedran.

The three Bank of Canada rate hikes since last summer are also expected to boost banks’ net interest margins, which is the difference between the money they earn on the loans they make and what they pay out to savers.

HSBC Canada, which reported its earnings for the quarter ended Dec. 31, serves as an early indication of what is to come for domestic lenders, although only two months of the reporting period overlap.

HSBC Canada reported a fall in profits, before income tax expenses, of $206 million for the fourth quarter, down 18% from a year earlier. However, net interest income was up 12.8% from a year ago, noted Aiken.