Podcast Transcript: Q3 Canadian Banks 2023

Daniel Stanley: Welcome to the 12^th episode of our deep dive series on Canadian bank earnings. Today we’re covering the third quarter 2023 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 the most equity and multi asset ETFs. In Sohrab Movahedi, Managing Director - Financials Research at BMO Capital Markets. Today, we’re going to be covering the recent bank earnings announcements and what they mean for investors as well as the Canadian economy. As well, we’re going to be looking at different ETF strategies that give you exposure to the Canadian banks. 

Daniel Stanley: So gentlemen, without further ado, thank you for taking the time to join us. And let’s get started and Sohrab. We always start with you, and I want to do the same this time. And particularly I’m interested in hearing about this because analysts have been revising bank EPS estimates earnings per share estimates lower pretty much since last June. And on our last podcast, you made a comment and I’ll quote here you said rate hikes will hurt the banks, margins will be lower, loan demand is expected to fall, and organic earnings growth is likely to be flat. How did the banks do this quarter? And was there anything in the results that contradicts your thesis that we’re in the early stages of a slower growth period for the banks?

Sohrab Movahedi: Thanks for having me back. Look at the quarter third quarter for the banks. Let’s stick to the six large banks. Only one bank exceeded consensus or our expectations in the quarter. The other ones were misses to varying degrees, I think and the bank that did beat had some tax rate tailwinds. Right, so the thesis that are the drivers that you were talking about, you know, slower long growth, basically the higher rates, hurting volumes, margins and the like. I think that’s largely intact. I think what we’ve heard with a louder voice from bank management teams is that they’re going to focus on areas that are within their control. Well, what control they have they have control over their risk appetite, ultimately, how much risk they’re willing to take. But I don’t know if that’s a near term answer to a slower earnings growth that can have some wins near term, but it may also have some medium and longer term implications. And in any event may take a bit of time to play out. But the more immediate lever that banks will have probably companies in general, but certainly banks will have because so much of the expense space of the banks is people is to manage their headcount and their expenses. What we got this past quarter was some elevated people related severance charges and the like at the banks and I think we got indications that there will be more of those sorts of expenses probably in the fourth quarter, the quarter we’re in that doesn’t end until the end of October. They won’t report it until December. So I think that’s point number one that expenses are now very much in play. Expense management is a priority and part and parcel and that will be some kind of headcount reduction. And I think Royal Bank, you know, the country’s largest bank, talked about reducing FTE by about 1%. Last quarter, with a further 1-2% kind of reduction in the fourth quarter, and the one that we’re in right now and BMO, which, which is a bank, we work for, obviously, and we don’t rate but they had elevated several strategies. 

The second thing, I think that’s going to be interesting, and I don’t know, if we got out of the quarter, we obviously expect normalization in credit costs and provisioning for credit costs. So remember that we had all this really excess government support that came in to hold the economy together, in response to COVID. That probably delayed what we were embarking on back in 2019, as far as the slowdown in the credit cycle anyway. And so we’re starting to get the credit cycle come through with the difference that there was an ample amount of liquidity pumped in historically, the credit cycles seem to have a clean peak associated with them when it comes to provisioning expense. Think of it as a rocky mountain kind of peak, we are starting to seriously contemplate whether or not to stay with the mountain theme, the credit cycle, this time around may look like Cape town’s tabletop mountain, you will have not a clean rocky mountain peak type that we have historically had during, you know, economic cycles, but a few years of, you know, higher and growing but not spiking, PCLs. And so you know, for anyone who could try and take a visual of that, perhaps the area under the curve will be the same, but the shape of the curve will mean a bit of a plateau top may serve source if you will, as opposed to a peak. And I think that we wonder how long it will take for that conclusion to kind of validate it. Right. So we’ve seen a bit of a normalization in credit cards, the PCL ratio is still around the quality through the cycle averages but it’s certainly drifting higher. 

The question is, is it going to spike? Or is it going to be a drift? And I think part and parcel of you know, that’s part and parcel of what sort of an economic outlook do you have? Certainly a soft landing scenario now seems to be the base case, and, you know, I think if you’re in a 0.5% GDP growth environment, I’m not sure if that’s very different than if you’re at a -0.5% GDP growth environment once a recession, one is not. Both are anemic growth. And so I think those will probably have to still get reflected on into the estimates, we revised our estimates a little bit lower for the out years, I wonder if if the sentiment towards bank stock, certainly fundamentally will become a lot more constructive. When we start looking at 2025 earnings estimates which we haven’t rolled out, we will roll out next quarter, we will have a better sense of what the exit velocity, if you will, for 2023 is going to be in 2024 still shaping up to be a bit of a, you know, I would say challenge operating environment for the banks, it’s certainly they would have some visibility into the first half of the year. And I think the commentary is managing expectations lower as we start looking to 2025 and beyond the case becomes stronger. So probably a bit more than just the quarterly recap that you were looking for. But hopefully it gives you a bit of perspective as to kind of how we’re viewing the space today and over the next three, six and 12 months.

Daniel Stanley: Thanks, Sohrab. I love that perspective. And I love the analogy of the sort of peaks versus the rounded mountain, the area kind of being the same. Maybe that drags it out a little longer. I’m curious and what I love about these sessions that we do, Chris Heakes what I love is that is that we can talk about the numbers and the results and then we can look at what the market thinks of those numbers and those results. What are you seeing from the perspective we heard the announcements were weaker from the market you look at the performance of ZEB which is the equal weight Canadian bank ETF talk to us about that price behavior what is the yield look like and what are trading volumes and flows on that ETF like

Chris Heakes: Yeah, thanks Dan. And good to be here again. The price behavior largely followed the fundamental behavior and I suppose that’s what you want to see and, kind of somewhat of an efficient market, with earnings generally, you know, a little bit disappointing to the downside Sohrab mentioned ZEB the BMO Equal Weight Canadian Banks Index ETF you know, kind of followed suit was down, 3-4% kind of off of earnings. I’d say since then it’s kind of trending back up. So you know, a lot of that ground that was kind of lost in that kind of one to two week span around earnings has been recovered. We had seen inflows, as banks have sold off, which is good, you know, it’s nice to see investors recognizing the opportunity, but you know, at the same time, I think it’s fair to say there are some, you know, there are some, you know, somewhat more nervous or concerned investors, you know, if you look at the Canadian banks this year, now, with this kind of recent recapturing of what was lost their about flat on the year just up 0.7%, you know, the TSX is up 7% Some of those growth elements like Shopify and IT helping the TSX this year, so you know, about 6% behind the TSX. You look at last year, banks underperformed the TSX, by about 4%. They were down 10. Last year, the TSX was down six. So you’re seeing, you know, certainly some concerns, I think we’ve been working through that. And you know, I don’t want to go too heavy on the numbers here. But I thought, you know, one thing that we looked at that was interesting is just looking at, we know banks as a long term investment are very, very strong. And we looked at, you know, when banks have a negative year, negative calendar year, which they did last year, what’s the average return the next year, and it’s +12%.

Obviously, we’re not experiencing that this year. But that’s the average over the past 35 years as far as we could get the data. Now, two years, if they have two negative years, which up until recently, we are tracking for a negative this year, now we’re slightly positive. But if they have two negative years, which only happened twice, it happened in 2000 and in 2009, where they had two negative calendar years. So, your average return the next year was 46%. So very strong, obviously. What am I saying here? Yes, we’ve had some kind of, you know, mixed operating environment challenges for sure. You know, banks are gonna be looking to cost contain and try and improve the numbers on that way. Yield to your question 5.1%, on the ZEB, traditionally, banks over five percents a pretty attractive level. And, I’m in agreement with, Sohrab, and my preferred view is not so much the three-to-six-month view, where it’s tough to forecast the challenges that are going to come, but that, you know, 2025 and beyond type view. And I think, you know, based on some of those negative price performances, the past, you know, one to two years, the future looking brighter on a two-to-three-year time span, especially as we could kind of look through the time horizon. So, yeah, again, with banks yielding over 5%, you know, that’s, that’s a pretty attractive level certainly helps in the meantime, if banks are, you know, not necessarily having the capital appreciation, you’re getting that 5% dividend, and position yourself for more capital growth potentially, in the years ahead. So that’s what we’re seeing certainly, like all equity investors, some anxiety. But you know, the anxiety also creates opportunity. And we have seen some inflows to the Canadian banks. net net, which has been nice to see.

Daniel Stanley: It’s interesting and sounds like it is a mirror image of what Sohrab was talking about where the PCL, historically it sort of spikes like a rocky mountain, but maybe we’re seeing a more rounded, what it sounds like is the performance of the bank equities, mirror image of that maybe, you know, you said flat 2020. Maybe it is going to be a rounded a slow, but not necessarily significant drop, which sort of makes sense when you look at a 5.1% yield very attractive for investors to hold on to a 5.1% tax efficient yield. While they wait for that flat ditch shall we call it to to gradually recover over time.

Daniel Stanley: Sohrab I want to come back to you, you know Canadian investors, we we tend to think of the big six banks as a monolith we always group them together, but in reality, you’re very well aware of this. They are quite different in where they tend to allocate capital. You know, BMO and TD, as we’ve seen recently tend to be focused on the US RBC very, very focused on wealth management, global capital markets. Scotia historically focused on the Latin American Market CIBC very focused on the domestic market, where I want to ask you the question. And where I’m curious is, do those differences? Is it enough of a difference to translate into better relative financial performance over the next couple of years?

Sohrab Movahedi: It’s a good question. I think, you know, just to kind of go back to what Chris was saying, we do think about the Canadian bank index, obviously. So there, we don’t really distinguish between them. You know, just to add a little bit to the data mining exercise that that Chris was just talking about. He was talking about the Absolute Return of the bank index, if I think about the relative return of the bank index, to the TSX. So the composite, it’s interesting that, going back to around 1970, which is the data set we’re going to look at, and this is I’ll call it a bit of a data mining exercise, you know, three consecutive years of underperformance is, is non existent, right. So we did have underperformance last year, we look to be underperforming this year. So, you know, and the markets being forward looking and what have you maybe some of that benefit that we’re talking about, with respect to 2025. And beyond, we’ll start getting reflected in the valuations in 2024, for example, so it’s a calendar year basis, it’s a data mining, it’s fun little exercise, I thought I’d give you that. But if you start kind of then disaggregating, this monolith, as we call it, you know, the bank index between its its component pieces, you know, I do think the differences become incredibly important, if we are talking about basically strategies for growth here. 

So let me come at it slightly differently and say that, if we have this kind of rounded, mountaintop on PCLs, as we were talking about, if sentiment remains a bit tired, if marginal buyers of Canadian banks, if non domestic marginal buyers of Canadian banks, which have to really first be sold on Canada, remain a bit cautious going on the macro, then stock price moves higher, are unlikely to happen anywhere near term through multiple expansion. And so the way up we’ll have to be pushing the earnings up and there the strategies become that much more relevant. I think banks that have made acquisitions have gone out and acquired earnings growth, I’ll call it probably are a bit more advantaged. You know, in this regard, BMO unrated by us, but last long weekend would have been the actual conversion weekend for the Bank of the West transaction. So, you know, provided they can execute and deliver on the synergies and like that they’ve advertised to the market. They have some installed growth, I’ll call it because of the acquisition. Royal Bank, similarly, yes, good and wealth management. But with the acquisition of HSBC Canada, which will probably close sometime in the first calendar year, let’s call it February/​March timeframe, again, relative to Royal Bank, not a massive acquisition as far as an earnings growth driver, but certainly provides some earnings growth support. Whereas the others may be, you know, maybe kind of working have to work a little bit harder be a little bit more of a self help story. Now, I think National Bank as an example may benefit from some of the disruption that will undoubtedly be caused by Laurentian Bank’s strategic review in Quebec, you know, there’s going to be disruption market over there, relative to National Bank, there’s going to be some opportunity to improve on things organically. But you know, banks like TD, which are sitting with a bit of a Department of Justice type restriction on them around capital deployment and aspects of their US business strategy are probably going to remain capital rich, but not so much. You know, earnings, maybe capital returning is poor, so to speak. You know, Scotiabank, going through a bit of a strategic review CIBC obviously trying to figure things out domestically. So you know, it gives you a sense that there will be a bit of a distinct disaggregation in that monolith. 

And I think you’re already seeing that, to be honest with you. You know, if you look at the relative values, if you think about dividend yield, we talk about that a lot over here, you know, dividend yield of the lowest dividend yield National Bank versus the highest dividend yield, you know, I think it’s around Scotiabank, or when we did this exercise a few weeks ago, you know, that yield differential is around a one standard deviation move, so to speak, relative to history, past 20-25 years. So the market is already providing some amount of differentiation of their I can speak to the ZEB but I can tell you in our fundamental approach, we’ve chosen to take a bit of a barbell approach where we have both expensive bank and I’ll call it cheap bank from a valuation perspective to you know, I’m just kind of construct a bit of outperformance and, you know, coincidentally or you know, by sheer luck, so to speak, the two that we rate outperform National Bank, a high multiple bank from book value, you know, dividend yield perspective. And CIBC, probably the cheapest bank now in a book value basis, and one of the higher yielding ones, certainly calendar year to date, have outperformed the bank index by sheer luck. But having kept our, you know, a toe both in the cheap and the toe in the high quality defensive, I think we’ve been able to, you know, benefit from periodic moves back and forth. 

I suspect, if Chris and I are right, and we’re moving towards a, again, I don’t want to think of the banks as a monolith. But I suspect if money starts flowing towards the banks, which I suspect will, as we look towards 2025, you would expect it’s coming in not to play defense, but it’s coming into play offense, I would, I would expect that will always result in a bit of a narrowing as opposed to further diverging, you know, some convergence is posted more divergence of those valuation multiples between the cheap and the expensive, if you will, whether it’s on price to earnings price to book or dividend yield. So, so a bit of a, you know, a bit of a mouthful, but I think near term, those ones that are able to show better earnings growth, probably because of acquisitions, or, in the first instance, ought to be a bit more in favor, but you know, taking some sort of a, you know, equal weighted approach probably allows you to also keep your toe in the water with the cheaper ones, as well.

Daniel Stanley: Thanks, Sohrab. I think we should hire you for our product team. Because I think Chris, what do you think you think a barbell bank ETF in the future to complement or equal weight bank ETF? I think it’s a great idea.

Chris Heakes: barbells are always nice, you know, they you got you got, you know, they help balance each other out. So yeah, they are often good way to do it.

Daniel Stanley: Let’s, let’s continue on that theme. And Chris, the next two questions are for you Sohrab by all means, feel free to chime in. But I do want to continue on that theme. Because Chris, you’re actually going to be managing shortly a new, long, short ETF that we’re going to be launching in October, which gives you some unique perspective here. Talk to us a little bit about what does the short interest look like in the Canadian banks right now? And in your opinion, what are some of the things that might either attract someone to shorting the Canadian banks, and what might detract someone from the idea of shorting the Canadian banks?

Chris Heakes: Short interest right now, it’s, it’s pretty, it’s pretty muted overall on the big six banks, so somewhere between call it 1 and 4%, just under 4%. I have CIBC as the most shorted bank right now at 3.6, and Scotia 3%. But, you know, I’d say relatively benign overall. Now, I just want to caveat to say this data is by no means authoritative. Its estimate, you know. So there’s that, but, you know, from what we see, you know, relatively benign, you know, of course, the US hedge funds, somewhat infamously have taken a couple cracks at shorting Canadian banks, usually driven by concerns about the housing market, you know, in general, you know, those kinds of, if you want to call them attacks, maybe that’s a little strong. But, you know, they haven’t worked out so well as long term trades. I remember, in the mid-teens, I met, that was a big theme in mid 2010s. Right, and as we know, real estate and the Canadian banks kind of had a great close to the 2010s. So, that’s, that’s one of the things that can attract them. And, conversely, by the same reasoning, I think, banks have proven to be very solid, not to beat the drum too much about long term investment and, high quality companies. And in the new strategy, thank you for mentioning long short, the types of companies we want to focus on underweighting are shorting would-be kind of more the lower quality companies. So, in general, banks don’t really fit the general model in terms of, one that you would have to have a large short but yeah, some of the dynamics are there and, yeah, so it’s a little tricky when you’re, again, when you want to short stocks, you want to kind of really identify something that’s lower quality overall, doesn’t tend to characterize the Canadian bank though.

Daniel Stanley: Chris, I want to continue with the next question for you, Sohrab, by all means, feel free to chime in on this one as well. This is more of a macro level; I think was last week Bank of Canada held their rates steady. And they noted that since the July rate high GDP growth, sir was revised lower for Q1, it was well below expectations for Q2, tracking significantly weaker for Q3. And yet they did say and I’ll quote them here ​“the Governing Council remains concerned about the persistence of underlying inflationary pressures” this does not seem to paint a very rosy picture for the environment in which these Canadian banks are operating. Talk to us a little bit about the US banks, how are they performing? More specifically, are there differences between sort of the mega cap banks in the United States and the regionals? What’s going on in that market?

Chris Heakes: Yeah, for sure. So, I think there’s definitely, you know, we saw some major differences in the regionals of course, in March it was the regionals that came under heavier pressure in general and saw, you know, a small handful of them fail, but they were they were large regionals. You know, the complexion as you know, that the US banking market is quite different than Canada. In Canada we really think about the big six primarily, and then there’s a couple others, kind of, I suppose you could say regional in our side. But, but in the US, it’s a much more fractured market overall. Yeah, so the regionals came under a lot of pressure, you know, they’ve bounced back, but keep in mind, they’re bouncing back from a larger decline. And, you know, the most recent earnings cycle, I think what we saw was some better earnings out of US banks, particularly the larger banks. And you know, the JIT. So think the JP Morgan’s the Bank of America. So, we saw in general some better, better performance there. 

So, I think the big question, though, to go back to the point of the operating environment is the macro, right. And so, it’s this distinction between the no landing scenario, the soft landing, and the hard landing. And in the US so far, consumers and employment, like tight labor market have kind of kept that needle somewhere between the no landing and soft-landing scenario, I’d argue. But what you are seeing to your point is central banks getting a little more aggressive, we just saw the ECB, the European Central Bank, somewhat unexpectedly raised rates, 0.25%. So, they’ve raised rates close to 5%, in about a year and a half, same similar to the US. And that’s certainly that’s going to create some economic pressure. So, again, you know, it’s kind of nothing new to see kind of an economic slowdown at the end of the hiking cycle, I think, as investors, we should certainly prepare for that and be aware of it, you know, having some defense in your portfolio, I think is, you know, makes a lot of sense, right? Now, you also want to have probably some growth in your portfolio, if we do get that no landing scenario. Where do banks fit in? Well, traditionally a little more cyclical. So, you have to be careful with them. But again, what I think what I’m kind of interested in is what kind of opportunities may be presented. 

So, I think, on a longer term, time horizon, time is your friend, in the case of investing, and sometimes not trading out of positions or acquiring positions over the years, building them up, tends to be a good strategy. But potentially, with this operating environment, we’re going to have better, you know, entry points in the next few months. So, you know, often it’s the investors who are who are able to say, I’m willing to buy when most other investors are sell tends to be, a little bit better. You know, as Warren Buffett famously said, I can’t say it any better is, you want to be greedy when others are fearful, and fearful when others are greedy. Great quote. And so, you know, in this environment, and, again, the next three to six months, a lot of uncertainty, we do have the central banks, again, trying to seemingly slow down the economy to slow down inflation, what kind of opportunities I’ve got to create, and, again, you know, when I think about taking risk in the portfolio, I want to take risk with exposures, I think are going to be beneficial over time. And I do think the Canadian banks are going to fit that bill, sorry, I transitioned from US banks to Canadian banks, maybe somewhere through that. US banks, again, just a little more risky than Canadian banks. So, I tend to and I’m not sure Sohrab if you’d agree, I tend to think of them as even more cyclical. So, I would just, personally, I take a little bit of a cautious approach on the sizing, but again, I you know, I think about what kind of opportunities might come and being ready to take advantage of those. 

Daniel Stanley: Excellent thanks very much, Chris.

Daniel Stanley: Sohrab I want to end off with a question for you, a question specifically, we’ve talked about this issue in the past, capital ratios. You’ve stated in the past capital ratios were very, very healthy. And correct me if I’m wrong, I think currently, Canadian banks have to keep a common equity tier one capital ratio at at least 11.5%, but there’s been talk of the regulator’s potentially increasing that to 12%. And I think it is, as soon as December. Can you talk to us a little bit about how our current capital ratios compared to this potentially higher level? Should we expect equity sales from the banks as a result? And how do you expect the market to react to this?

Sohrab Movahedi: It’s a regulated business, the regulator primarily looks to the amount of equity capital that’s on the balance sheet. Because you know, if you mispriced your -I mean, it’s a leveraged business, right. So therefore, if you’ve mispriced your assets by, you decide, 5%, you could wipe out your equity, The regulator usually regulates you to your capital, because they’re worried about the depositors in the first instance. And so I think we have a very solid regulatory environment here, I think the banks are very well capitalized. The regulatory minimum today in Canada is 11.5%. But just for crystal clarity, that includes about 3.5% of what let’s loosely call a counter cyclical buffer or a domestic stability buffer. One that basically as the capital ratio, you build, essentially, as the regulator like psychology, you buy insurance during good times, so that you could actually release it during difficult times, so that the banks can continue to play that shock absorber type role that you need them to in an economy, as it turns, you know, you want loans to be flowing, and what have you. The range for this shock absorber, the domestic stability buffer, officially called over the counter cyclical range has another 50 basis points on it, the regulator in Canada reviews this every six months or so. So twice a year. The next review is December, like you noted. 

And I think, you know, the broadly speaking, certainly our working assumption is that, you know, they will take it up to 12%, or add the final 50 basis points remaining on the range. But still the rule or the expectation is that that’s because there’s ample capital in the system, not because they’re trying to force the banks into equity sales and what have you. So I guess long way of saying no, we don’t anticipate a further bump in the capital levels for the bank through the domestic stability buffer in December to result in capital equity issue sales by the banks, largely because they are not instantaneous. Yes, market discipline may start asking of the banks, are you within compliance, all the banks today are in the 12.2% and above? So you would say even if the regulatory minimum moves to 12%, the banks as of last quarter, we’re already clear of that higher regulatory minimum. And the regulator in Canada has historically been disciplined but rational, right? So they don’t necessarily say and you need to comply by this next week, there’s usually a five or six month period to comply, which gives a couple of quarters of internal capital generation, one of the, you know, important attributes of the Canadian banking system is that they are comparatively speaking, higher R O E banks. Obviously, higher capital ratios will kind of squeeze that ROE a little bit, but they’re still very good internal capital generation, because of those kind of premium ROEs. And so even if a bank is close to that 12% line, assumed higher 12% line, there could always be an unforeseen circumstances, legal charges, what have you. That would be a couple of quarters up in total capital generation.

So not worried about it from an equity issue. perspective. But look, it’s a regulated business, if the capital levels continue to grind higher, which is the phase we are going through right now. And you have an emboldened kind of regulatory environment globally post the Silicon Valley debacle in the in the US. You know, we would expect that to be a bit of a headwind on ROEs for the banks, right. So don’t worry about the capital issues from a capital adequacy perspective, kind of more worrying more from a return on equity and therefore, you know, what does it imply from evaluations perspective? That’s how I think I would basically leave it there I think they’re resilience if the arrow is are good, but certainly that hard to make a case why they would be going higher from here, if the denominator continues to drift higher.

Daniel Stanley: Guys, thank you very much. You know, I love these sessions the insight from you guys, Chris love the insight again about the Data Dive that you take on, you know, in years of negative performance, what kind of positive performance do you have in the following year on the banks Sohrab love that disaggregation of the so called monolith and you know how, in the next couple of years are going to be driven by the individual banks growth strategy. Really great insights from you both as always, thank you for doing this. As a reminder to the audience you can get exposure to the Canadian banks via ZEB which is the BMO Equal Weight Canadian Bank Index ETF you can get exposure to our US banks via ZUB or ZBK, which is the BMO Equal Weight US Banks ETF and if you have any questions, please don’t hesitate to visit the ETF Center at bmoetfs.com. That’s all for today, folks, thank you for tuning in. Please join us in December for the next update on the Canadian banks.