The Canadian bank index is at roughly the same level it was two years ago – a very rare event. Coming out of COVID, the sector rallied to a new peak in February 2022 when inflationary concerns took the index down over 20% in the following months, to levels it has remained on and off since. Part of the reason Canadian bank stocks have not risen over this period is because profitability has remained within the relatively narrow range of $14 bln and $16 bln in the past 8 quarters, while the macro environment has remained uncertain. In this insight, we discuss three ways the banks could “clean up” fQ4 earnings and help set the stage for an improved f2024.
Back to the banks.
Historically, in challenging operating environments, Q4 has often been a “clean-up quarter” for the Canadian banks, allowing for higher/cleaner earnings the following year and more favourable year-over-year comparisons as a result. We believe there are three ways the banks could seek to “clean up” their fQ4-23 results and set the stage for an improved fiscal 2024.
First – and most likely – the banks could book restructuring charges to reduce forward run-rate expenses. Reining in expenses is almost certainly among the sector’s top priorities as inflation-induced expense growth has put pressure on operating leverage, a key reason bank earnings have struggled to grow. In the past, individual banks have reported charges in the hundreds of millions of dollars. Potential charges could result from staff reductions (particularly in capital markets), closing/combining branches (particularly outside Canada), and/or selling off underperforming assets or businesses. The benefit to shareholders would be to reduce run-rate expenses which could support higher earnings estimates.
Second, the banks could look to write-down or sell assets where the value has been impaired, for example, marketable securities with unrealized losses or goodwill and intangibles. The most likely candidates are related to the U.S. banking subsidiaries, where: (i) the rapid rise in rates and held-to-maturity accounting has resulted in unrealized losses in securities portfolios; and/or (ii) the carrying value of the associated goodwill/intangibles related to the initial acquisition/investment may have declined following the recent mini “banking crisis”. A third possibility is goodwill write-downs of investments in wealth management assets acquired in the last five years.
Overall, the banks carry enormous amounts of goodwill and intangibles on their balance sheets, and there are likely opportunities to lower carrying values given the weakness of the markets and ongoing economic uncertainty. A benefit of selling securities with unrealized losses would be higher net interest income if the proceeds are reinvested into higher yielding securities. Writing down goodwill and intangibles would not impact earnings or regulatory capital but could provide a marginal benefit to ROEs.
Third, the banks could consider an accelerated build of loan loss reserves, especially performing allowances, which are set aside for loans still current in interest and principal. Changes in this giant reserve have been a huge contributor to earnings volatility since COVID. Even though this is a “non-cash” item, the market has interpreted the building/releasing of this allowance as a “signal” by management that credit could get worse/better. Moreover, the sheer materiality of builds/releases of this reserve on reported results makes it relevant.
As of the most recent quarter, performing allowances reached a very large ~$20.5 bln, supported by five consecutive quarters of builds totalling $3.4 bln. Given the ongoing economic uncertainty, it is possible the banks seek and/or are required to materially build this reserve in fQ4 taking it closer to the COVID-peak of ~$24.5 bln. On the other hand, an end to performing reserve builds would be a positive for two reasons: (i) it would remove a persistent and highly material earnings headwind; and (ii) it would give comfort to the market that management believes that they are adequately reserved for this operating environment.
Canadian Bank Stocks Continue to Price in a LOT of Bad News
2023 has been a very messy year for Canadian bank earnings. That said, the sector is weathering the storm, keeping profitability stable in an environment with rising loan losses, large reserve builds, NIM headwinds, and tepid capital markets. In our view, fQ4 could see the banks take a combination of the discussed measures to help put as many issues behind them as possible to allow for a better f2024.
Trading at ~9.2x f2024 estimates (8.9x f2025 earnings) on average, Canadian bank stocks are very inexpensive and clearly pricing in significant challenges ahead including another huge increase in forecast loan losses from a possible recession. In a more normal environment – characterized by reasonable GDP growth and a stable macro environment – the banks would likely trade around 10.5x earnings, or roughly ~15% higher than today’s levels. In our view, a combination of the following catalysts is needed for Canadian bank stocks to see multiple expansion and/or upward revisions to forward estimates: (i) Bank of Canada signals it is done raising rates; (ii) evidence that inflation is definitively subsiding; (iii) a cessation of performing allowance builds; (iv) stability or moderate improvement in credit trends (since consensus estimates forecast a sharp rise in non-performing loans and related losses); and/or (v) an improvement in capital markets.
Hamilton ETFs, Your Home for Canadian Bank and Financials ETFs
Hamilton ETFs is the #2 provider of Canadian bank ETFs, accounting for over $1 bln of the firm’s $2.8 bln in AUM. Investors seeking exposure to the Canadian banks might consider: i) the Hamilton Enhanced Canadian Bank ETF (HCAL); (ii) the Hamilton Canadian Bank Equal-Weight Index ETF (HEB); and/or (iii) the Hamilton Canadian Bank Mean Reversion Index ETF (HCA). For those looking for broader exposure to the Canadian financial sector, they might consider our Hamilton Enhanced Canadian Financials ETF (HFIN), and/or Hamilton Canadian Financials Yield Maximizer ETF (HMAX).
|ETF||Ticker||Indicated Yield (paid monthly)||Style||Sector Exposure|
|Hamilton Enhanced Canadian Bank ETF||HCAL||8.08%||Growth (25% leverage) + income||Canadian banks|
|Hamilton Canadian Bank Equal-Weight Index ETF||HEB||5.44%||Growth + income; lower fee||Canadian banks|
|Hamilton Canadian Bank Mean Reversion Index ETF||HCA||5.86%||Growth + income||Canadian banks|
|Hamilton Enhanced Canadian Financials ETF||HFIN||6.78%||Growth (25% leverage) + income||Canadian financials|
|Hamilton Canadian Financials Yield Maximizer ETF||HMAX||15.50%||Income||Canadian financials|
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Video: Canadian Banks – Weathering the Storm | June 8, 2023
Video: Market Outlook with Ed Yardeni | May 16, 2023
Video: Canadian Banks – What’s Next | April 11, 2023
Canadian Banks: Opportunities and Risks in 2023 | January 23, 2023
A word on trading liquidity for ETFs …
Hamilton ETFs are highly liquid ETFs that can be purchased and sold easily. ETFs are as liquid as their underlying holdings and the underlying holdings trade millions of shares each day.
How does that work? When ETF investors are buying (or selling) in the market, they may transact with another ETF investor or a market maker for the ETF. At all times, even if daily volume appears low, there is a market maker – typically a large bank-owned investment dealer – willing to fill the other side of the ETF order (at net asset value plus a spread). The market maker then subscribes to create or redeem units in the ETF from the ETF manager (e.g., Hamilton ETFs), who purchases or sells the underlying holdings for the ETF.
 S&P/TSX Composite Diversified Banks Index (Total Return)
 Based on the universe of ETFs that trade on the Toronto Stock Exchange, as of September 14, 2023.
 An estimate of the annualized yield an investor would receive if the distribution remained unchanged for the next 12 months, stated as a percentage of the net asset value per unit on September 14, 2023.
 The downside is that restructuring charges weigh on growth of regulatory capital.
 As of September 8, 2023.
 An estimate of the annualized yield an investor would receive if the monthly distribution remained unchanged for the next 12 months, stated as a percentage of the net asset value per unit on August 31, 2023.