Podcast Transcript: Q2 Canadian Banks
This podcast was published on June 10, 2022Jun. 10, 2022
Daniel Stanley: Welcome to the seventh episode of our deep dive series on Canadian bank quarterly earnings. Today we’re covering the second quarter 2022 bank earnings announcements, and we will return each quarter on this channel to update you on the latest financial results. My name is Daniel Stanley. I’m an ETF specialist at BMO Exchange Traded Funds. I’m joined today by my friends and colleagues, Chris Heakes, Portfolio Manager for all of BMO’s equity and multi-asset ETFs, and Sohrab Movahedi, Managing Director, Financials Research at BMO Capital Markets. Today, we’re going to cover the recent bank earnings announcements, and what they mean for investors and the Canadian economy, as well as looking at different ETF strategies that give you exposure to the Canadian banks. So, without further ado, Chris, Sohrab, thank you very much for taking the time to join me.
Why don’t we get started? Sohrab, I want to start with you. I want to start by looking at the present, because on our last podcast, you noted that all six banks exceeded Q1 consensus expectations, and that it was a solid start to 2022. What about Q2? How did the banks do this time around?
Sohrab Movahedi: Again, it’s good to be back. I say it was pretty consistent with the first quarter final assessment. This time five beat. One was a 1% miss, so I’ll call that a push. Collectively, they reported a little over 15 billion in after-tax cash operating earnings. That was 5% higher than a year ago. On a fiscal year to date basis, we’re halfway through. As a group, they’ve now delivered just around $31 billion in after-tax earnings, which is 10% higher than the comparable period last year. So, they did pretty good.
I’d say one consistency in this quarter was they essentially exceeded expectations. The other one was that the source of those better-than-expected results were the credit provisioning levels. Credit provisioning levels remain embarrassingly low across two groups. The PCL ratio, the provision-for-credit-loss ratio, was two basis points. If we think about the banks and we look at them through the cycle, PCL ratios, it would be in the 35 to 40 basis point range, versus the two basis points this quarter. And a couple of years ago, during the peak of the pandemic, they were close to 150 basis points. So clearly, the pandemic-related reserve-building two years ago is proving to have been overly conservative and a gift that keeps on giving.
On the rest of it, I’d just say that long-lived business diversification last year, there are few businesses like investment banking and trading and capital markets and wealth in general, were shouldering the brunt of it. And the baton looks to be being passed to the deposit-taking lawmaking operations, an enduring benefit, if you will, for the next little while of the central bank rate hikes.
Daniel Stanley: That’s great. Thank you, Sohrab. Chris, on our last podcast, you mentioned that rising rates were benefiting financials. But this had to be balanced off with the geopolitical risks that existed out there, namely, Russia’s invasion of Ukraine. Now, the risk of recession has to be added to this balancing act. Chris, if you’re looking at our ETFs with bank exposure, what are the markets saying about financials on an absolute basis and maybe also on a relative basis?
Chris Heakes: Yeah, thanks, Dan. And also great to be here. It’s a challenging year for investing. It is certainly a balancing act along a few different dimensions. If you look at the price evolution of the banks since our last podcasts, they were under a lot of downward pressure, and the markets were as well, but the banks were down about 15% from mid-February to mid-May. The broad index in Canada has been a little bit of a beacon of relative light within the scope of world equities. But even then, the broad index was only down 9%, so, Canadian banks were taking it on the chin in terms of a price perspective. The view that we were going out to clients with was this would be an adding opportunity at the time. But of course, to your point, we have to mention that it’s balancing risk versus reward. Recession risk: in our view, it’s not imminent, but it’s certainly out there, maybe out in the future a couple of years. Geopolitics is obviously huge. In terms of rising interest rates, we still think that’s going to be a tailwind for banks, but investors did not like to see the flattening yield curve out there. Since this sell-off of 15% that I mentioned, it looks like the market’s starting to restore its confidence in banks. I do think there’s a little bit of a, “Where else can you go?” or a, “There is no alternative,” but banks are pretty solid, fundamentally. We’re coming out of this quarter with cautious optimism. As Sohrab said, by no means did they knock the lights out, but performance was pretty solid on the bottom line, dividend yields up 4%, they’re trading at 10x earnings.
We’ve seen this preference across our suite for more high-quality investments this year. We’ve seen dividends outperforming, for example, companies that have current earnings. And I think the banks do fit that mold, so to speak. So, challenging markets, lots to balance, but most of our investors are needing to stay invested. And I think that the bank exposure is one that’s fitting the current shape of the market, and we are seeing some client flows into banks and dividend strategies there.
Daniel Stanley: Thanks for that, Chris. Sohrab, I want to come back to you because Chris mentioned the dreaded “recession” word, and even though he says it’s not imminent, I feel like in each of our previous podcasts, it felt like the bank’s financial results, which are typically backward-looking versus stock prices that are forward-looking were in sync. There was a sense that you could extrapolate optimism into the future. Now, it feels like with both rising rates and a little bit more economic uncertainty on the rise, it feels like that synchronicity, and the ability to extrapolate strong performance going forward, is being tested. How can you see the banks weathering this uncertainty?
Sohrab Movahedi: There’s no doubt that rising rates, inflation and the overall economic cycle are definitively top-of-mind for investors, certainly, with bank investors that we speak with, mostly, because it looks like central banks have to be a lot more upfront with it, with the pace and number of rate hikes to manage inflation, relative to their transitory expectations they have. So, if I just think about that for a second, and the bottom line here is higher central bank rates, are either intended to fight off inflation, the environment we’re in, or too hot of an economy and intended to slow it down. So, it’s understandable that higher rates, certainly rising rates at the kind of pace that is expected by the markets, may be cause for pause for Canadian bank investors, I suppose.
The financial markets have priced in their own expectations. So, there is obviously, right now, a bit of catch up, if you will, between where the financial markets expect to see the 10-year being, versus where the rate hikes will take it. But now, because of some of these worries that come with rising rates, participants are a little bit more willing to look past the benefits and look at the worrying credit quality implications associated with debt service ratios, for example, which will come under pressure, and consumer credit and corporate profit margins, which come under pressure, not only for higher funding costs, with the higher rates, but also, the tighter labour market and higher energy. So, in other words, the potential for a slowdown, if you want to call it the dreaded recession, is a lot more omnipresent, and the current environment has factored this into investment decision-making when it comes to banks. And I’ll reiterate what Chris was saying that February, when we really saw the first set of rate hikes coming through between February and end of May, that was a 600 basis points on the performance for the Canadian bank index. Interestingly enough, and I like data mining, one of the things we did is we looked back to 1970 and found, prior to this environment that we’re in right now, 10 other instances where there had been a 15% or more backup in the Government of Canada 10 years, and in nine out of 10 of those instances, the bank index had underperformed. These would have been, obviously, varying durations, but the bank index would have underperformed the broader market during those rate rising cycles. The good news though for bank investors is that in eight out of 10 of those in the preceding or in the following six months, when financial markets had picked off on where the rates are going to be, the bank index has outperformed both in the next six and in the next 12 months. Now, I’m not a race expert. I know we’re worried about recession, but it sure as hell feels like we’re very close to the point where the bank index can actually embark on a period of outperformance, let’s say, in the coming six to 12 months.
Daniel Stanley: That’s great, Sohrab. Chris, you brought up the point that between February and May, the banks were down 15%. Sohrab, I love that point that you make that, going back in time when we saw rate increases, we saw that a decrease in the bank index is actually quite normal. And subsequently, we have seen that in previous circumstances, oftentimes, the banks play catch-up from that point onwards. So that’s a great way to tie those two together. And Chris, you pointed out exactly that, but since then, the banks have certainly recovered quite nicely.
Chris, I want to come back to you. And let’s talk about inflation a little bit here. The inflation stats have been extremely high around the world, and Canada is no exception, and rising prices tend to focus an investor’s attention on companies that pay stable and rising dividends. Companies that are benefiting from inflation, such as energy companies, are another beneficiary. What other ETFs might an investor look at to get exposure to financials as well, to the broader theme of an inflation hedge?
Chris Heakes: Yeah, for sure. Daniel, you mentioned there’s a couple of sectors that benefit from inflation. Energy’s top-of-mind. Not sure if it’s the only a accretive sector, but the only meaningfully accrettive sector on the TSX this year. So obviously, energy is playing a role there. But, as well, you can think of it from a factor point-of-view, which is how I like to think of it, and one of the big shifts we’ve seen in the market, obviously, with inflation high, we’re seeing rates go up to address that high inflation.
And the big rotation that we’re seeing is this rotation from growth to value in yield. So, companies with earnings further out, kind of the lifecycle, call it like, maybe semiconductors or growth, IT, they’re being punished. Companies with current earnings, current cash flow, and good valuations, sustainable dividend yields, are doing relatively well. And I do think banks are characteristic of factors, as well. So, the products that I think have really been well positioned and continue to be is, is the dividends. So, in Canada, that’d be ZDV, the BMO Canadian Dividend ETF. And then we have ZWC, which is the BMO Canadian High Dividend Covered Call ETF, which employs that covered call overlay for some extra income. But if you go back and look at high inflation environments, you can see it proving out in the data, again, like Sohrab was saying, you’re going to have to go back, you’ve got to take your, your testing window back a lot to get data on the environment that we’re in now, but both value, as well as dividend yield, tend to outperform broad equities during these periods.
So, if you look at those dividends, again, there’s a pretty high financial weight and Canadian dividend strategies, and we have about 40% respectively, in those two. Energy is about 20%. It’s benefiting from this inflation trend. But overall, when we construct these dividend portfolios, we’re not looking for the highest yielders, and that’s often not the way you want to build a dividend portfolio. You want to look for quality dividend-growers, companies that are sustaining their dividend yield. And that’s really what’s been in preference by investors this year in the market, especially with all those other risks that we talked about in the background. So, both ZDV and ZWC are actually positive this year. There’s not a ton of equity that is positive this year, but they’re up 4-5%, each, so far this year. So, I would say, for someone looking to potentially benefit from these themes, this has been a good trade, and I think it’ll continue to be because we still have a few more interest rate hikes to navigate. I feel like inflation is going to come down, but it’s likely to be sticky. It’s going to take some time. So, I think there continues to be a good place for investors and a place where you can be a little bit more defensive, as well, relative to the broad market, should other risks increase. So, I’d suggest the ZDV and the ZWC, have places you could look.
Daniel Stanley: Thanks for that, Chris. Sohrab, I know we’ve talked about this on previous podcasts, but I just I can’t stop thinking about that double-edged sword issue of inflation, rising rates, and then their impact on the economy and the banks. Because, as we’ve talked about, on the one hand, banks can increase prices, but on the other hand, higher prices, or an economic slowdown, will reduce demand for some of those products or services. For those who want to gauge an economy’s strength by looking at the financials of the banks, what metrics measures are the most appropriate, in your opinion?
Sohrab Movahedi: Maybe the best way to kind of put it is, if you think about commercial or business lending, historically, that has been incredibly procyclical. It’s a little bit hard to know which one’s the chicken or the egg, but these seem to coincide. So, I’d say you keep an eye on commercial loan growth. I’ll tell you, this past quarter, the commercial loan growth was double digits across the banks, so, it’s coming along quite nicely. If you wanted to get a feel for the bank’s outlook on the operating environment and the economy, obviously, is very, tantamount to that. I think it could pay attention to the dividend growth trajectory. And I think it was mentioned a little bit earlier that they gave us dividend increases, and Royal Bank of Canada gave us a 7% dividend increase, so, if that is not, I suppose, an indication of management’s optimism on its earnings trajectory, I don’t know what it is.
And as we start going into a slower economy, the one thing that you hope the banks are doing, and I think accounting under IFRS 9 is increasingly requiring them to do this on a proactive or forward-looking basis, is look to see what credit-reserve-building they are doing. It certainly doesn’t have to be that performance, or the quality of the book has deteriorated, but it would be their signal that they anticipate some degradation in their credit quality. And, like I said, this quarter anyway, the reserve levels were still embarrassingly low. Now, this is a tale of two kind of halves, if you will, there’s the bit of reserve-building that maybe you do as you grow the loan book, and anticipate some degradation in credit quality because of higher energy costs, or funding costs and the like, that are the macro indicators for talking about inflation. But it’s also offset by some amount of reserve-releasing that you’re required to do by your auditors, given the level of conservatism that would have been exercised in building up those reserves in response to the pandemic. So, those would be the three or so things that I think bank investors can probably pay attention to. But you don’t ever want to say, “Don’t worry, be happy,” but you have to also be competent that Canadian bank executives, CEOs and Chief Risk Officers and the like, are constantly paying attention to those things. And if you were going to whittle it down to one thing, then you look at their capital ratios, and the capital ratios of the Canadian banks are at very high levels. I don’t think anyone expected them to do as well, not even them, as they ended up doing through the pandemic. So, capital is aplenty; reserve levels are adequate; dividends are going up; and long growth is slowing down, but is still indicative of a healthy economy.
Daniel Stanley: That’s great. Thanks, Sohrab. Guys, I want to end off this session, as we often do, talking about real estate. Chris, can I ask you start off with your thoughts on real estate now that the cost of borrowing is rising. So, Chris, I’ll start with you. And then Sohrab, if you can just chime in after Chris.
Chris Heakes: I think it certainly got really hot, didn’t it in, in February. There are probably different pockets out there, but it looked like everything got really hot. Obviously, coming off the highs coincided with interest rate hikes. Like you said, borrowing is more expensive. I’m in the mild correction camp, and it might be 10%, 15%, but I think there’s still a lot of strong demand. If you look at where the economy is, employment’s strong right now. So, if the U.S. GDP comes in negative next quarter, they’re in a technical recession. But it’s not really a recession when your employment stats are strong. So, I think there’s a little more downside if that bends the other way. But for now, I’d say maybe a mild correction, just to take some of the heat off the market with the higher rates. That’d be my two cents on that one.
Sohrab Movahedi: I’d say we look at it from a banks’ lens. So, on the one hand, higher real estate prices in Canada, in particular, have meant higher collateral values for the single largest loan class on the banks’ balance sheets. So, the loan-to-values are probably below 50%. Mortgages have, obviously, been a very important driver after long growth, along with commercial double digits as well, so, a mellowing out of the housing market brought about because of, let’s call it, higher rates on the one hand, will slow down longer. On the other hand, they put a little bit of pressure on the collateral values from a quality of the loan book perspective, but from really really high levels.
The real estate asset class in Canada, mortgages, in particular, because of the insured nature, on the one hand, or the high down payment requirements, tends to be a very “capital-lite” and ROE-accretive, one of the highest ROE, I’ll call it “loan categories” for the banks. So, as real estate slows down, as growth of mortgages slows down, the factor will be a bit of a headwind, if you will, to the ROE of the banks, but the banks are operating at this mid-teens ROE level, like I said, or very high capital levels. So, it’s not a huge concern of ours, but it’s something that is factoring into our TRM estimates.
Daniel Stanley: That’s great, guys, thank you very much. This has been a great session. I think the two things that I’ve jotted down that really stick with me, Chris, were your discussion about the focus on quality dividend-growers, and Canadian banks certainly fit into that category. The dividend ETFs are not focused on yield; they’re focused on looking at quality dividend-growing companies. Sohrab, the one point you made that stuck with me is for all those armchair economists out there who are trying to forecast a recession, but looking at the banks and that the rules of thumb that you can look at things like commercial loan growth, look at the dividend growth trajectory, look at credit-reserve-building, and also their capital ratios as indicators of what the banks may be preparing for in the future. So, thanks for all of that insight. Folks, as a reminder, you can get exposure to Canadian banks via ZEB and ZWB. All four ETFs trade actively on the TSX. You can get exposure to US banks, which we did not talk about today, by the BMO Equal Weight US Banks Hedged to CAD Index ETF (Hedged Units) (ZUB) and the BMO Equal Weight US Banks Index ETF (ZBK), or the BMO Covered Call US Banks ETF (ZWK).
If you have any questions, please visit our ETF Dashboard at bmoetfs.ca for research, news and insights. That’s all for today, folks, thank you for tuning in. Please join us in mid-September for the next update on Canadian banks.