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Natalie Taylor, CIBC asset management, portfolio manager.
The Canadian banks are set to report fiscal Q2 20 earnings the last week of May. A lot has happened over the quarter, resulting in a wide dispersion of estimates heading into the quarter.
As always, the U.S. banks report first and can offer investors some insight into what might be in store given the uncertainty. The biggest takeaway from U.S. bank reporting is the greater-than-expected increase in loan loss provisions given the deterioration we’ve seen in the economy. We believe the Canadian banks’ experience will be similar and could possibly be more severe given an extra month of the lockdown — an April quarter-end versus the U.S. banks March quarter-end — a more stretched consumer in Canada to begin with and greater exposure to the oil and gas sector, which has been particularly hard hit.
The U.S. banks also had an offset from higher capital markets activity. However, this is likely to be less pronounced in Canada as a lower percentage of earnings are derived from this segment.
Perhaps the biggest question on banks currently is what the impact of a low interest rate environment is on profitability and liquidity. Interest rates have fallen precipitously as central banks have attempted to stimulate the economy. This will have a lagged negative impact on banks’ margins and profitability over time. However, the magnitude of credit losses tends to have a much bigger impact on bank profitability in a recession.
Also liquidity, while we did see some stress in financial conditions emerged back in March, the Fed and the Bank of Canada have since flooded the market with liquidity, which has lowered borrowing costs and improved the functioning of the financial system. It’s worth noting that since the financial crisis, regulators introduced liquidity requirements and increased the quality and quantity of capital [that] banks must hold dramatically.
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. We believe the near term outlook for the bank sector is challenged given the uncertainty in the economy with regards to the depth and duration of the recession.
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. We believe this process will play out over the next six to 12 months.
It is important to put these comments in context. While we do believe that earnings will 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.
Currently our preferred sub-sector within financials is property and casualty insurers. This industry has much lower interest sensitivity, limited exposure to credit risk and is currently experiencing improved pricing power as meaningful industry capacity has been wiped out. Covid-19 has further supported pricing trends as investment losses across the industry have further reduced profitability.
In the commercial space, we like W.R. Berkley, a U.S. specialty underwriter with a strong track record, and Fairfax Financial, a Canadian specialty and reinsurer.
In personal P&C, we believe the near term outlook is even more compelling as a significant reduction in miles driven is expected to reduce claims costs materially. We like Intact Financial in Canada, given its scale and prospects for growth through industry consolidation, and Progressive in the U.S. given its best-in-class underwriting, low-cost model and prospects for growth.
We also like alternative asset managers, particularly for Brookfield Asset Management, which has a defensive tilt having just purchased distressed credit manager Oaktree. BAM also has significant liquidity to recent raised funds to put to work opportunistically in this market.