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Natalie Taylor, portfolio manager at CIBC Asset Management.
The Canadian banks reported their second-quarter results in the last week of May, and generally results beat expectations basically across the board. And beats to consensus ranged from 8% to 18%, so quite meaningful. The primary driver of the earnings beat was continued improvement in credit costs, which also included reversals of previous credit provisions as the economy continues to recover here. So, provisions for credit losses appear to have peaked in the third quarter of 2020 and have been declining since then.
The second factor was capital markets earnings. They were nearly double the level of the prior year. It’s important to note that the prior year was the height of the pandemic, and activity was at extremely low levels, but capital markets has been a strong source of earnings for over a year now. It’s not often viewed as a sustainable source of long-term earnings growth, but the segment does continue to surprise to the upside.
Net interest margin is showing signs of stabilization, so recall with lower interest rates at the start of the pandemic that really compressed margins over the last year. We’re starting to see those margins level off now, with some steepening of the yield curve.
Loan growth was very strong in mortgages — that should not be a surprise to many of us that are familiar with the Canadian housing market. But loan growth was more muted across other areas, so commercial and corporate clients are continuing to repay draws on lines of credit from a year earlier that were primarily precautionary in nature.
Lastly, I would say that operating leverage was a positive. So, revenue growth is exceeding expense growth in the period and that’s generating some good operating leverage.
Overall, we saw some very favourable results from the banking sector and that was reflected in the share price moves we saw.
In terms of the outlook for banks, while bank earnings and valuations have recovered meaningfully over the last year, we do think there’s more upside driven by continued economic recovery. The first source of upside and potential catalysts we believe will be the Canadian banks being able to return increasing amounts of capital to shareholders. This could happen as early as next quarter, although the exact timing is uncertain.
Recall that a year ago OSFI the regulator put a freeze on increasing dividends and a freeze on buybacks as well. That was really to ensure that banks preserve their capital in a period of uncertainty. So, OSFI, which has been historically very conservative as a regulator, has publicly said that additional capital return is vaccine dependent. The risk of further lockdown and economic disruption really needs to be in their rearview mirror. 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.
As you can imagine, over the last year the banks have accrued significant amounts of capital. 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.
TD and BMO have some of the highest levels of capital. We could see additional deployments of capital potentially through M&A as well.
In addition to increased capital return, we think there’s upside from higher short-term rates, which is not priced in at all at this point. While the Bank of Canada and the Fed rate hikes are viewed as unlikely, I think until 2023, this could start to get priced in over the next year. Rate hikes can add quite meaningfully to earnings, as we saw in the last rate hike cycle around 2018. Banks disclose sensitivity to a 100 basis point increase in rates, and TD would be best positioned and we could see 7% earnings growth from higher rates, while the remaining banks would be more in the 5% range.
All in all, we’re seeing the type of momentum from the banks that you would expect during an economic recovery. We think that they’re well positioned to benefit from continued recovery and economic expansion.