Podcast Transcript: Q3 Canadian Banks
This podcast was recorded on September 8, 2022.Sep. 8, 2022
Daniel Stanley: Welcome to the eighth episode of our deep dive series on Canadian bank quarterly earnings. Today, we’re covering the third 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. And 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 in the Canadian economy, as well as look at different ETF strategies that give you exposure to the Canadian banks.
So, without further ado, Chris, Sohrab, thank you for taking the time to join me. Sohrab, I’m going to start with you, because these podcasts are a great way to take a step back and look at how the six Canadian banks performed, versus expectations. And in Q1, you noted that all six banks exceeded consensus expectations. Then in Q2, I think it was five exceeded and one had a near miss. What about Q3? How did the banks do this time round?
Sohrab Movahedi: Morning. It’s good to be back. The slippery slope persists, relative to consensus expectations – I’d say two misses, two near misses and two beats. So, there was a bit of a deterioration or high expectations; however, you want to think about it. Relatively speaking, we can talk a little bit about the ins and outs of that, but you know, if you sit back a little bit and think about the title we had a year ago, in Q3, coming out of the quarter in 2021, we would have called it reserved releases, revenue diversification and rebounding (ROE).
I’d say this quarter, the results – like I said, call it two misses, two near misses, and two slight beats – definitely one thing we saw, compared to a year ago, was a move towards – and you know, this is not a technical accounting term, but I’ll call it pre-emptive reserve-building. This is either in anticipation of a less vibrant operating environment. Obviously, we’ve all heard about the impact of inflation and higher energy prices, and what have you, but very macro-driven, no real signs of degradation in credit quality. And so probably some degree of conservatism, but probably an important part of the reason of some of these near misses would have been the changing stance, if you will, in credit-reserve-building at the bank. So, still good. I don’t think any of the banks are talking about a base case scenario of a recession or anything like that. But suffice it to say that, relative to expectations, I guess as the plot thickens, we’ll see what we have to say next quarter.
Daniel Stanley: That’s great, Sohrab. Thank you. And I like the way you’ve actually sort of segwayed into the next question for Chris, in your point that a lot of these moves were macro-driven. Chris, I want to come over to you and talk about that macro picture, because there’s no better picture oftentimes than just looking at the stock prices. And on our last podcast, you noted that bank stock prices were down between February and April, and they bounced back in May. Talk a little bit about how stock prices performed since we recorded that last podcast in early June.
Chris Heakes: Yeah, thanks, Dan. Good to be here as well. Like Sohrab said, I think the plot has thickened in general markets with macro. And one thing we’ve seen and have been talking more about is that increasing risk of recession has come back a bit into the fore. So, just to give you some numbers to put it all in context, from the end of May, when we last recorded, ZEB, our BMO Equal Weight Banks Index ETF, is down 10% and the TSX is down 6%. So, banks are underperforming, which we sometimes typically see when those kind of fears of economic slowdowns happens. But it’s a little bit aggressive, in my opinion, and I will circle back to that in a second. S&P was down 3%. U.S. banks, just for context, were only down about 5% in the last quarter. So again, Canadian banks are being punished a little bit more.
One thing we’ve seen is energy equities in Canada are down about 15% over that time. So, as that fear of recession has increased, oil has trended lower. Overall, we’ve seen inflation remain pretty high. It eased off in our last reading, but it’s still pretty sticky. And you’re seeing relatively aggressive hiking paths by various central banks, including the Canadian central bank. And I think that’s helped increase that fear of the recession, because obviously, that fear of a hard landing has increased with some of the policy path.
But all that being said, the plot has thickened, and no one has all the answers, obviously, but Canadian banks, I think, are taking a little bit more pain, than perhaps they should. Overall, when we put it into context, and we’re going to talk more as we go through, there are some constructive points, including dividends, but they’ve kind of taken it on the nose a little bit from a price action perspective. But again, one thing that creates is a better long-term opportunity. So, I’m sure we’ll get more into that. Obviously, quite volatile markets, and we’re seeing banks kind of bounce and move around a little bit off the back of that.
Daniel Stanley: Clearly, banks are underperforming because of that fear of that economic slowdown. And Sohrab, that brings me to the next question, because on the last call, you mentioned that an armchair economist who wanted to get a sense of how close we are to a recession might look at banks, and there were four key things. One was commercial loan growth. Two was dividend growth. The third thing was credit-reserve-building. Then the fourth thing was capital ratios. Can you talk a little bit about, generally, how the banks are faring in those four areas?
Sohrab Movahedi: Yeah, and look, before I even answer that, I will add a little bit of fuel to the fire, I suppose, and say coming out of the quarter, we probably had, at the margin, turned a bit more cautious on the environment for the banks – nothing specific to the banks, but on the likelihood of slower economic activity, and obviously, banks are typically levered plays on the economy. And so, if the economy is going to slow down, that will have a negative ripple effect, if you will. We titled our post-view note as, “Winter Is Coming,” so it will be interesting to see a year from now when we look back if that was prescient or not. But if you think about the four drivers you talked about, I certainly mentioned one of the reasons for, call it, “misses,” relative to consensus expectations in the quarter, would have been, again, what I would characterize as pre-emptive reserve-building. So, we’re starting to see a little bit of action, some movement, on the credit-reserve-building, but in fairness, we are coming off abnormally and unsustainably low provision levels for the banks. And part of reason for that is, obviously, we had off-the-charts reserve-building in response to the COVID-19 pandemic, a couple of years ago, so we are kind of going through this period of things settling back in. We had to over reserve as an industry, those reserve releases were coming through, and I suppose you could say, the reserve releases have slowed down, and some reserve-building is coming through. So, I guess check mark over there.
I mean, obviously, we didn’t get any dividend increase announcements this quarter, but that’s not unreasonable, because you don’t necessarily get them every quarter. What will be interesting is whether or not the cycle for some banks that has been semi-annual persists, or if we end up moving on to some sort of an annual cycle. We’re not expecting a change in the trajectory over there. So that leaves you with capital ratios and commercial loan growth. Commercial loan growth is still fairly vibrant, and that seems to be quite pro-cyclical. So, again, if we’re worried about a slowdown, then we should start seeing that in the commercial loan growth, and certainly, we didn’t really see that yet.
Anyway, this quarter in, the capital ratios remain very healthy, so much so that a couple of the banks, Royal Bank and Scotia, would have continued with their buyback programs. But I do think what’s interesting is, you’re neither hearing the banks talk about it, nor do I think the investors are necessarily expecting that those buyback programs will be renewed. So again, as part of a belt and suspenders, let’s call it, I suspect we’re going to be in a period that will last a few quarters, if not a year or probably at least a year anyway, where the banks will be in capital preservation mode.
On the one hand, that’s because probably, they just want to have the belts and suspenders in place, just in case. On the other hand, as the economy slows down, and we don’t need to necessarily call it a recession, or a hard or soft landing, but presumably, there will be a degradation in the credit quality of the borrowers, whether it’s commercial or consumer borrowers, and maybe we’ll talk about that in a bit. And so, that will probably mean further reserve-building. And so, dividends stay in check, but you will see a bit of a moderation in loan growth, presumably, preservation in capital and some reserve-building.
And we ultimately have taken the stance here that Q3 marks the first part of that cycle. I’m not an armchair economist, but I will play the armchair economist’s role and say, the one thing at least we pay a lot of attention to is the slope of the yield curve between the 10-year and the three months. Historically, that has been a reliable predictor of higher loan losses at the Canadian banks, something on average of six quarters past the yield curve inversion, do you see the peak PCLs. You know, we had some of the inversion of that part of the curve in the last couple of weeks, and so if you believe the historic average that six quarters from now we’re going to have peak PCL, then it could be a couple of quarters before the markets feel comfortable that they have their arms around it and therefore have adequately reflected that peak, if you will, or reserve-building, notionally, in the valuation. We think the valuation is largely reflected, but I don’t think we are quite there yet to declare the “all clear,” to see the rewriting. I think that might still be a couple of quarters. A bit of a long-winded answer, but hopefully a complete one.
Daniel Stanley: That’s great, Sohrab. I appreciate it. And the theme that I’m definitely getting from both you guys is that idea that there is a theme of turning more cautious, but it’s really sort of a macro-driven environmental thing. Chris, this brings me back to you because stock prices react to macro. They react to company-specific issues. While bank stocks have been weak this quarter, and Sohrab pointed out that you expect dividends to stay in check, dividends do tend to be that far more stable source of return when it comes to owning the banks. Can you talk a little bit about bank yields? How do they stack up to historical levels? And, you know, how might an investor look for solutions with higher yields, given the current levels of inflation that we’re seeing?
Chris Heakes: Yeah, thanks, and I think this is the good story of the bank. The good side of the debate is dividends. And, when we look at the underlying dividends of the Canadian banks, I’ve got data going back 30 years, and there’s never been a dividend cut. And so, I honestly don’t know when the last one was. But it’s quite a while ago. Obviously, banks didn’t cut during the financial crisis. They didn’t cut during the IT bubble. They didn’t cut during the COVID-19 crisis, as well. So, definitely a solid source of income for investors and one that Canadians have always gravitated to.
We did publish a piece on our Dashboard that looked at the forward returns of Canadian banks conditional on yield levels. And I don’t think it’s a surprising result. But, you know, it was a very robust result. And again, you can come look at the data on our ETF Dashboard. When that underlying dividend yield is higher, dividend yields are going to be higher. When prices are lower, all things being equal, that forward return is much better when that dividend yield is higher. So, when you’re getting dividend yields on the conditional, the long-term average is about 4%, again, a very healthy level, and one where we tend to have dividend growth in the stocks, but when we have dividend yields in the 4.5% or 5%+ range, you tend to have very good forward returns associated with that, compared to when dividend yields are lower, like in the 3% or 3.5% range, below average.
So again, I don’t think it’s a surprising result. But in terms of where we are, right now, we’re about 4.7%, in terms of dividend yield across the Big Six, in our equal-weighted approach, which we use in our ETFs. We’ve got a couple that are healthfully over 5% in CIBC, and Bank of Nova Scotia. So, it’s a very healthy level of yield. And historically, when we’ve had yields in this level, close to around that 5%, it’s been a good buying opportunity for investors. So, yes, do banks have the potential to sell off more? Of course, if recession fears elevate, if we did have a turn and kind of economic or employment data, that would create concern, and we’d likely see all equities trade sideways. But I think the best recommendation for investors is to look at them as a long-term hold.
I think we’ll look back in two to three years, and identify this as being a good buying opportunity. So, that’s how we’re looking at it. And then, just in terms of that comment on inflation, certainly, a challenge for all investors. CPI is going to come in this year around 7% increase and, and next year, it’s forecasted to moderate a bit, but as we all know, inflation is being sticky. Income and income investing is one way to help counteract that. So, yes, bond yields are getting more attractive, but they’re not “7% attractive,” or if they are, you’re in a much higher credit risk of space, whereas the Canadian banks, you know, using that cover call as an example, where that product is yielding about 7%. That’s pretty much in line where CPI is, so using that covered call approach or even just using the outright dividend approach with these healthy dividend yields does give investors an ability to keep pace with CPI from an income perspective. And then, obviously, we’ve been talking about a lot of challenges to navigate. But you know, over time, we believe the banks are going to be capital generators, as well just having to navigate the current environment. So overall, in terms of combating the current environment, I think the dividend and dividend growth aspect, and the covered call approaches, are some of the shining lights about the exposure that can help carry them through this market.
Daniel Stanley: That’s great, Chris, thank you very much. Sohrab, I’m going to shift over because we’ve been talking a lot about macro-level issues. I want to shift over to something a little bit more specific. One of the things I noticed was that Canadian banks often look south of the border for growth. Oftentimes, these acquisitions involve risks that have to be managed. And this past quarter, there were two Canadian banks that booked accounting losses as a result of, and I’m going to quote here, “hedging against the impact of changes in interest rates related to acquisitions.” Can you make a general comment for the audience on the nature of these transactions, and how these losses or gains impact the overall performance of the banks, if at all?
Sohrab Movahedi: Before I answer that question, I just want to add to something that Chris was saying around the enduring history of Canadian banks and their commitment to dividends. I think he said he had gone back 30 years at the beginning of COVID-19. I think we went back 80 years. So, you may have a period where they don’t increase dividends. We had that obviously, during COVID-19, most recently, but dividend cuts are rare, and we don’t expect them, and we expect dividend payout ratios, then ultimately to stay around where they’re at right now, and from time to time, they may get to the upper end of that 40% to 50% target range. And I think they’re around that point, and so, we think that dividends are safe, dividend yields are there and dividends will probably at least grow with earnings.
The second thing I’d say before I answer your question is that we went back and looked at valuation multiples on the Canadian bank index, through the last four, I’ll call them “recessions” or “economic slowdowns. Obviously 2001, the TMT crisis, wasn’t really a recession in Canada. In 2015-16, we had the energy slowdown. I don’t know if you want to call it the recession, but then we also, obviously, had the global financial crisis and COVID-19 in there. So, when you think about those four periods of an economic slowdown, or recession, and you look to see the forward P/E multiple price/earnings valuation of the Canadian bank index, it tends to average. So, I’m not talking about where it troughs. I’m talking about the average through the duration of the economic slowdown and looking at monthly data, and it tends to average around 10.5x. As of last night’s close, the bank index is trading at 9.1x. So, I think that also would tell you that we are probably close to bottom levels here, and it will likely be a good buying opportunity for patient investors. So that was additive to what Chris was saying.
Specific to your question, the quick answer to this is “accounting noise,” and not economically substantive to the underlying fundamentals of the bank. Here, I guess we’re talking about TD, which we cover, and BMO, which we don’t cover and we’re restricted on, but conceptually, both of the transactions that these banks have announced are “fixed price” transactions. So, what that entails is you’re attributing some value to the assets, and then the difference between the value of the asset and the price you have agreed to pay, which doesn’t shift, is goodwill. Now, when you go through a period, and these assets, obviously are loans basically, and loans are kind of like bonds. When rates go up, the face value of the bond or the market value of debt loans comes down. So, what ends up happening here is, let’s say they agreed to a fixed price. In the case of First Horizon, interest rates have gone up since they announced the transaction. Then by definition, the value of the assets, which are basically loans, have gone down. When the value of the asset goes down, but the price of the transaction doesn’t change, then more of the price being paid is being counted towards the goodwill and of that equation.
That goodwill, for regulatory capital purposes, is a deduction, if you will, from capital. Now, some banks – BMO would have been one – right at the beginning of the announcement of the transaction, would have put hedges in place, which basically is intended to immunize the volatility to their capital ratios, such that if the value of the transaction skews towards goodwill, because the price of the assets go down as rates go up, then let me find something that appreciates in value by a similar amount when rates are going up, so that I can flow it through my capital account and immunize my capital issue. That’s the intention of it, obviously, when the deal closes, the immunization becomes irrelevant, because that’s when you actually have the goodwill deduction. So, in the intervening period, you’re going to have the positive impact of the hedge that you’ve put in benefiting from the rising rate, but you know that’s going to be spent, if you will, when you close the transaction. Perhaps a bit too detailed for the purposes of this call, but bottom line here is that it’s not economically consequential. What happened from a BMO perspective, when they announced the transaction, they had the hedge in place. TD did not have that hedge in place at the time of the announcement, but a couple of quarters subsequent, they announced this quarter, that some existing hedges that they have in place, they have basically de-designated and really pointed towards this. I’ll call it, again, “accounting noise,” not substantive to value creation or destruction, as far as the shareholders of the bank are concerned. Hope that helps.
Daniel Stanley: Thanks, Sohrab. That’s extremely helpful because the important point is we see these things in the news and they are big numbers, and then people might panic when they see them. So, it’s great to get that perspective that you have on what these transactions are. I’ll call this “Acquisition Hedging 101” – fantastic information. Thank you.
Chris, I’m going to come back to you and talk about a different issue that can be equally as tricky sometimes for people to get their heads wrapped around. And that’s the issue of liquidity – important these days, as we’re seeing volatility pick up. Investors tend to discount the need for liquidity by either ability to sell their investments until it really matters. And we know that with ETFs, daily volume isn’t always indicative of the true liquidity, which comes from the liquidity of the underlying exposure of an ETF. Can you talk about the liquidity profile of ZEB and ZWB, in particular?
Chris Heakes: Yes. Thanks, Dan. It’s nice to have a little bit of an easy one. Like you said, when you’re looking at ETF liquidity, you really take your indication from what that ETF holds, and the liquidity of that underlying exposure is typically going to dictate the liquidity of the ETF. And Canadian banks that are held in ZEB, the Big Six, they’re all fairly liquid in the Canadian marketplace. And if you look at the average liquidity of them, it’s $2.4 billion a day. So, on average, across the six, about $400 million dollars of traded volume on each of those six banks. So, there’s deep liquidity there.
ZEB is actually one of our most liquid ETFs, just from a share perspective, so ZEB trades 3 million shares a day, with a $33 NAV. Now, that’s about $100 million a day. So, ZEB is very liquid, and ZWB, the cover call, was also quite liquid and trades at about $10 million a day. But again, the true liquidity of ZWB and ZEB, for that matter, is much more because the underlying banks are so liquid. So yeah, exactly, like you said, getting in and getting out, even in challenging markets. Certainly not going to be much of an issue for Canadian banks. One other nice thing that we’ve seen grow over time is an options complex around ZEB. So, we use that option complex when we manage our covered call strategy, but there’s many other investors. There’s the open interest around that ZEB has over 1.5 million contracts, as of now. So, quite a developed liquidity infrastructure, and helps investors get in and get out when they need to do those transactions.
Daniel Stanley: Thanks, Chris. That’s, that’s fantastic. I always think the litmus test for securities is the option contracts that are out there. And it’s interesting that ZEB has hit 1.5 million in that respect. So, a great sign from a liquidity perspective.
Sohrab, I want to come back to you as we often do. I want to finish off this discussion on the Canadian banks with the topic of real estate, as it’s hard to avoid it. There have been a number of economists that have been in the news lately, quoting statistics having to deal with falling housing prices, inventory of unsold homes. Can you shed some light? Are we seeing this impact Canadian banks? And if so, how?
Sohrab Movahedi: Obviously, housing is an important driver of the Canadian economy. Historically, mortgage growth, or let’s call it real-estate-secured lending growth – let’s compare home equity lines of credit in there as well – have been around 2x nominal GDP. We’ve also had very good, vibrant, long growth in Canada. And you see that.
So, when you talk about housing, my lens into it is twofold. One, what does it tell us as a barometer on the economy? And then secondly, what does it tell us as a barometer on long-term growth for the banks. From a long growth perspective, mortgage growth continues to be good, but as every one of the banks will tell you, it’s not sustainable. And that makes sense, because of two reasons, mostly because cost of money is going up, but also because of the base effect. So, when you’ve had pretty robust growth on big numbers, it’s going to be hard to continue to maintain that growth. And so, the banks are telling you that mortgage growth is going to slow down. But obviously, house prices will also be an input, not an only input a driver of their outlook on the forward economy, and what happens with the macro drivers of the outlook of the forward economy will have an impact on what sort of reserve-building they will have to do.
So, this quarter, they would have factored in their economists’ expectations to some extent. That would have meant a slower economic growth, probably because of lower house prices. That would have probably dictated some amount of, I’ll call it, “pre-emptive reserve-building.” And that pre-emptive reserve-building is something we talked about, that may have been part of the reason for some of the misses, relative to expectations. What matters here is that we see the housing topic as less of a credit issue for the bank. So, we don’t expect the bottom to fall out and there’s going to be a hole blown in the side of the balance sheet because a gazillion dollars of mortgages will have to get written off or anything like that. So that is not the issue.
The issue really is, without the beneficial wealth effect of appreciating house prices, consumer spending habits may moderate, and if you have a moderation in that, then it could generate slower economic activity. And if there is slower economic activity, then obviously, it weighs on the economic growth and brings us back full circle to, well, banks are levered plays on the economy. And so, it’s going to be a more grinding-it-out type of environment, as opposed to anything else. So, I’m not worried from a credit-quality or reserve-building or capital-attitude perspective, more from a what does it mean as far as income statement growth perspective.
Daniel Stanley: Thanks, Sohrab. That’s really helpful and a great way to close this discussion off. For the audience, the key takeaway is the fact that house price is not a credit issue, but more of a wealth-effect issue, which goes back to our theme in the earlier discussion, which is that at the end of the day, the banks are being a little bit more cautious. And the stock markets are reflecting that, as Chris pointed out, but the issues really are these macro-level issues. They’re not bank-specific issues. And I think that’s the important takeaway.
An equally important takeaway – and you both drove this point home – the good story here is that dividend, which, Sohrab, you pointed out hasn’t been cut over 80 years, and through difficult times, the bank multiples are trading at attractive levels. Chris, you pointed out that when we see dividend yields in this range forward, returns on the stock prices tend to be pretty good. So, I think those are all very, very important takeaways for the audience today.
Chris and Sohrab, thank you. In these volatile, changing times, this kind of insight is particularly helpful. As a reminder to the audience, you can get exposure to Canadian banks via ZEB, ZCN, ZWB and ZDV. All four ETFs trade actively on the TSX. You can get exposure to our U.S. banks, via ZUB, and 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-December for the next update on Canadian banks.