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Craig Jerusalim, Senior Portfolio Manager at CIBC Asset Management. I specialize in dividends and GARP mandates.
Canadian banks are set to report first quarter earnings over the next several weeks, and there are some conflicting macro factors that are at odds with a very strong backdrop for the Big Six banks. Canada’s economy has never been more dependent on household spending as it is today, and with mortgage interest rate payments significantly rising over the past few years, and housing pricing stalling out, the Canadian consumer can best be summed up as fatigued. Auto sales have turned negative for the first time this cycle, further questioning consumers’ propensity to consume. The good news, however, is that the key leading credit indicators are not flashing any red or yellow lights as of yet. The unemployment rate is low. Credit card delinquencies are benign, and consumer competence is still relatively high.
So, coming back to the Canadian banks, despite a less certain period of economic growth, and the Bank of Canada hitting the pause on rate hikes, bank valuations are still extremely compelling. The banks are trading at close to nine times next year’s earnings, despite mid-single digit earnings growth, and sustainable dividend yields in the 4 to 5% range. The banks are extremely well capitalized, and are not showing signs of stress at this point, outside of some idiosyncratic exposures such as General Electric and PG&E bankruptcy. The key drivers that we’ll be paying close attention to as the banks report are net interest margins, loan growth, and provision for credit losses, as well as updates on those idiosyncratic exposures.
The banks saw margins expand when the Fed and the Bank of Canada were increasing interest rates. However, no further expansions are being built into expectations at this point. Therefore, cost controls will be needed to realize operating leverage in 2019. We have tempered our outlook for loan growth moving forward in order to line up with our views on the consumer, but commercial and US loan growth are still quite robust. As for the provisions for credit losses, they can’t go any lower, but they can stay benign so long as those leading indicators continue to cooperate. To sum up, the Big Six banks are a good proxy for the Canadian economy, but the inexpensive starting points, strong oligopoly within the Canadian banking system, the high-end growing dividends as well as capitalized starting points make the group an attractive place to invest from a risk/reward perspective.