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By Ruth Saldanha |

Will the bumpy ride for banks in Canada continue?

Will slowing loan growth and rising credit costs continue to weigh on the financial sector? Morningstar's Eric Compton shares his thoughts and top Canadian bank picks

Securities mentioned in this video
National Bank of Canada
Canadian Imperial Bank of Commerce

Ruth Saldanha: Canadian bank earnings took a hit because of a slower economy, deteriorating credit quality and weaker equity markets, especially in the last quarter of 2018. What will happen this year? Morningstar Analyst, Eric Compton, is here to tell us what he expects.

First up, what do you think of the latest bank earnings? Are you at all worried?

Eric Compton: So, I would definitely agree that Q1 earnings for the Canadian banks were not stellar. Almost all of the banks took a pretty decent hit on their capital markets operations and so, you know some cited deteriorating trading margins and most of them cited just lower activity within some of the equity capital markets and debt capital markets. So, you know, that sector took a hit for all the banks. That was not helpful, and we also did see some increases in credit charges and provisioning.

And so, if I was going to be worried about one item, it would not be the hit to capital markets operations. We think that will turn around eventually, especially with the pickup in the markets going into Q1 of calendar 2019. However, I would be a little worried about the credit metrics, and so we have seen some deterioration in things like delinquencies, and that has been occurring in Canada and in portfolio that we're watching closely such as the mortgage portfolio. So, I would definitely keep my eye on that.

Saldanha: What do you expect from the banks for the rest of this year?

Compton: So, our overall thesis on the space is that we would expect slowing overall growth driven by slowing loan growth because of what we see as an unsustainable growth level, particularly in the Canadian property markets. And we would also expect an increase in credit cost, which would also hit earnings. So, our overall thesis on this space is, over the medium-term slowing earnings growth, slowing loan growth and some deterioration in returns.

Saldanha: One thing that everyone is keeping an eye on is the interest rate cycle. What is your view for interest rates for the rest of this year?

Compton: So, the last time the Bank of Canada raised interest rates was back in October and they have maintained rates steady ever since. And in their most recent meeting, they also announced that they were maintaining rates and they really highlighted the slowing growth in the Canadian economy as well as the more dour outlook for the global growth picture as well. And so, while the outlook is more negative, we are encouraged that at least the Bank of Canada is slowing down its pace of rate hikes and we would not be surprised if they remained patient for the rest of 2019. This is a similar stance that the Fed has taken in the U.S.

Saldanha: Finally, what is your favorite Canadian bank pick for the year?

Compton: So, currently, the National Bank of Canada and the Canadian Imperial Bank of Commerce are both the most undervalued when compared to our current fair value estimates. The Canadian Imperial Bank of Commerce, unfortunately, did see some increases in some of the credit metrics we talked about earlier, some negative increases in things like delinquencies and charge-offs and provisioning. And so, that was kind of a negative, but we are encouraged that they are also growing their real estate secured portfolio in Canada the slowest right now. And so, we appreciate that they have taken a step back and they still have top tier return on equity. So, we think there is some valuation gap there, but because of their outsized exposure to the property markets, we do think that name also involves in those risk.

National Bank of Canada, they took a big hit in the quarter from certain capital markets activities. We think that will turn around. Overall return on equity is still solid for the bank and we also think there is just a bit of a valuation gap there and maybe a little bit less risk, because they are more concentrated in the Quebec area as opposed to areas such as Toronto or Vancouver.

Saldanha: Thank you so much for joining us here today Eric.

Compton: Thanks for having me.

Saldanha: For Morningstar, I'm Ruth Saldanha.

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