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(Runtime: 7 min, 16 sec; size: 5.07 MB)
Stephen Carlin, managing director and global head of equities, CIBC Asset Management.
So what should investors expect for the Q2 reporting season for the banks in Canada? I think we expect to see tepid performance. Q1 performance, which was reported just a couple of months ago, saw capital markets businesses quite weak, which was a disappointment to the market. However, when the market looks at capital markets profitability and returns, we do know that it’s a cyclical business and therefore I believe a lot of investors felt that trading and investment banking businesses would rebound. And as we’ve rolled closer to the end of the Q2 season here, we see that perhaps the expectation of a nice rebound was a little over-optimistic. And so from that perspective, we’re expecting the banks on the capital market side of the business to report better than Q1 but not to what investors may have been expecting for Q2.
Now the good news is a number of the Bay Street analysts have been following this closely and so I think some of that is baked into the current valuations as more and more investors become aware that this business has not recovered. And as result, I do believe that the softness that we’re going to see in that part of the earnings profile to the banks is somewhat baked in.
Now on the other aspects of the business for the banks, the other thing that I think was significant and fairly material was the fact that interest rates played a bit of a whipsaw in the sense that market participants really thought that we were in a trajectory for a higher interest rate environment. However, we saw both the U.S. Federal Reserve and the Bank of Canada step back from that, and as a result of that we saw interest rates fall somewhat. And why that’s important to investors in the bank stocks is that really, what would be positive for bank earnings would be a rising interest rate environment.
And so from that perspective, on the interest rate front, I don’t think we’re going to see a dramatic change in margin. We call that the net interest margin. So between the first quarter and the second quarter, I think now we should expect a flat environment or perhaps ever so mildly negative. And when I say mildly negative, we’re talking basis points. So not really enough to move the needle, although all I’m saying is that where we thought we may have had a little bit of a tailwind, the interest rate environment has turned into something that’s not helping earnings at all.
Loan growth should be positive. We think commercial loan growth continues to truck along in that low to high single-digit growth range, so that should be positive. Commercial real estate, we believe, is going to be good. Consumer loan growth will be pressured. We think that mortgage growth had been tepid, largely due to a softer real estate market. And so as we look at all of that, we do still think that the banks can exhibit loan growth, that’s important. And so from that component of the equation, that should be a positive for the banks.
Lastly, markets have been up. No question the markets have been much improved over what we saw in the fourth quarter or final quarter of the calendar year. As a result of that, we expect to see fee income rise for the banks, especially in the asset management businesses because we have seen a fairly significant increase almost across the board globally from a year-to-date perspective on stock market returns. So mid-teens in the U.S. and Canada as well as Europe. In some segments in the Asian markets they’ve been even stronger than that.
In mid-April there was some conversation from some noteworthy hedge funds in the United States on a more negative view towards the Canadian banks. What I would offer is a couple of observations. First, the hedge funds were alleging that the Canadian banks had manufactured their earnings by reversing credit provisions during the year, which our fundamental research has suggested is very fatally flawed in the assumptions and the mathematics of their assumptions. And in fact, what the hedge funds are talking about was very incorrect. In fact, what happened is a number of the banks were actually increasing the provisions on credit during 2018 which was actually a headwind, meaning it was a negative impact on earnings. And so from that perspective this is what makes a market. Some investors are allowed to have those opinions. We differ on our views and believe strongly in the way that we analyze the businesses. And so from that perspective, we believe people’s assumptions are incorrect and that creates that market opportunity, of course.
The second thing is that the allegations were that the banks had been artificially raising their capital ratios by underweighting the risk weightings for real estate exposure. And I would highlight that one of the important components of both government policy and the way the banks has been operating has been a much stricter environment in terms of underwriting standards. And one of the things that we can also point to and why you need to have a broader understanding of both the Canadian market and other markets and why they’re different is that while you can apply some similar assumptions that you might for U.S. companies or U.S. banks, it’s very different in Canada.
And what I would highlight is that the Canadian banks on two fronts. Firstly, a large proportion of mortgages that are underwritten are underwritten with both CMHC or other mortgage insurance. And secondly, when you look at the loan to value of the bank’s mortgage portfolios, the loans outstanding relative to the value of the properties that they’re underwriting is currently at 55%, which is very conservative—meaning the banks have very, very significant cushion in their underwriting standards relative to any potential shrinkage in the value of real estate. And from that perspective we also believe the assumptions and the estimates that have been thrown out there are somewhat flawed. We think the Canadian banks from both a positioning perspective and a underwriting perspective are in much better shape than implied by some of those reports.