Podcast Transcript: Q1 Canadian Banks

Daniel Stanley: Welcome to the sixth episode of our deep dive series on Canadian bank quarterly earnings. Today, we’re covering the first quarter 2022 bank earnings announcements, and we’re going to 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 of 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 looking at different ETF strategies that give you exposure to the Canadian banks. So, without further ado, Chris and Sohrab, thank you for taking the time to join me. 

Why don’t we get started? And sir, I want to start with you. On our last call, you said that, and I quote, ​“The key to happiness in life is to set low expectations.” And you pointed out that a year ago, expectations around bank earnings were quite low. Now, last quarter expectations were higher. But most of the banks exceeded those expectations with this first quarter of fiscal 2022.

Sohrab Movahedi: Dan, thanks, it’s good to be back. Look, in Q1 2022, which really ended last week, I’d say all six of the large banks, again, exceeded consensus expectations, most at a place like BMO or National where they beat by 19%, the consensus expectations for the quarter. The the least was at TD. But even it was a beat with about a 2% better than results. Just as a sidebar, it was interesting to see CIBC also announced a two-for-one stock split this quarter. The last time we had a stock split amongst the Canadian banks, TD and National did it back in 2014. 

Following Q1 2022 results, we raised our estimates for the banks in 23, by about 2% or so at two of the banks, really left them unchanged for Royal Bank, and then increased it about 3% on a couple other ones. Our estimates, basically, were the reasons why we had higher target prices now for some of the banks, specifically Scotia, CIBC and National, and then we lowered our target price actually on TD on the back of a lower forward P/E really relating to an acquisition, which we could talk about maybe a bit later, because of the integration risk and use of their excess capital. But regardless, our revised target prices now imply high single-digit total return potential still for the banks, that obviously includes the dividends, which are quite attractive. 

And under Canadian banks, our total returns would be a little bit higher on the cheaper stocks, I’d say the ones that are trading at a lower valuation multiple. So namely, forward P/E here, CIBC and National, and a bit lower on the likes of Scotia, Royal and TD, but overall, a good solid start to fiscal 2022. And, with all the geopolitical tensions out there, it may prove to be a bit of a hard act to follow in the remaining quarters, but a nice solid start to the year.

Daniel Stanley: Thanks, sir. And that’s a great segue into the next question for Chris. On our last call, you mentioned that Omicron was a curveball that slowed some of the gains in financials toward the end of last quarter. Fast forward to today, and the new curveball appears to be Russia and their invasion of Ukraine. Chris, can you talk to us a little bit about how financials have reacted to this news and why.

Chris Heakes: Yeah, for sure. And also, great to be back again with you on this on this call. Omicron, curveballs, I guess that’s what that’s what makes the markets the markets. It’s funny with Omicron, you know, there were about three, four days, where there was some pretty severe concern, but I would say, or at least from a market perspective really, that recovery started happening in early December. Obviously, the actual wave was more late December into January, even into now, but the market got past that. 

But, like you mentioned, as it got past that curveball, certainly the Ukraine situation was a much even bigger one. In some ways, I think it’s fair to say it was a surprise to at least most the vast majority of market participants. You know, I think there was a thought that Putin may stop at those two kinds of regions in the east that were quite sympathetic to Russia. But the invasion of Ukraine, and you can see this in financial markets, was not particularly anticipated or priced in. So, what you see in the markets has been, obviously, underperformance, in particular Europe, now down, about 20% off the back of this. What you’re seeing is generally that risk off tone, with cyclicals underperforming and financials are often in those cyclical buckets. So, if you look at financials in Europe, they’re down 20%. 

You know, you’ve seen some of the rates coming off. And I know, we’re going to talk about rates a little bit later. So, I’ll save the conversation, but some of those expectations of interest rate hikes have come off a little bit in terms of North America, and, taking that focus back to Canada, certainly less dramatic of a sell off, although it is starting to catch up a little bit, but I don’t think it’ll get to that that situation like we’re having in Europe and European banks.

So, I think it’s a very interesting situation in North America. You’re seeing that mix of kind of what I would say were the major themes driving the market this year, where we were looking for value versus growth to outperform the interest rates hikes happening, you know, really strong, results from Canadian banks. Now, we have to pair that off against the risk-off trade, due to geopolitical conflict, and the potential impacts of further supply shortages, such as an energy. 

So, financials, on one hand, have some strong outperformance in terms of results, but obviously, geopolitics is weighing on the entire market. And, when you have these sell-offs, they tend to be those more cyclical sectors like financials and banks that underperform a bit. So, I think it’s an interesting inflection point and, it’s actually, an opportunity to look again at the Canadian banks. If you look at ZEB, it’s off the highs of, call it, a mid-$42 range, trading around $40 right now – so almost 10% off the highs, not quite, but if you look at it now, it has a 3.8% dividend yield. I’d be interested in Sohrab’s comments, if we get any more dividend growth coming this year. I think maybe there might be that opportunity. So, I think it’s an interesting moment for investors who are willing to say, let’s think six months down the road, do we get out of this Ukraine crisis? And what does that look like? And I think it could be the case that the banks are going to have an improved outlook, versus where they are today. So, I think it’s an interesting moment for investors to continue to consider Canadian banks.

Daniel Stanley: Thanks for that, Chris. Really appreciate that. And, Chris, I know you talked a little bit about interest rates there, and Sohrab, I want to touch on the issue of central bank policy with you now. The Bank of Canada increased interest rates on March 2 by 25 basis points, and they are expected to follow with four or five more increases, based on what you’re seeing in market pricing right now. Fundamentally, this should be good news for the banks who should see lending margins rise. It’s interesting, because the last time the Bank of Canada increased rates to this extent was between July 2015 and September 2018, when the target overnight rate went from half a per cent to 1.75% in a series of five increases. And during this period, we saw ZEB, our BMO Equal Weight Banks Index ETF, return 52%, or 14% annually. So Sohrab, do you agree that rising rates are good for the banks? And should we expect the same kind of reaction from the banks this time around?

Sohrab Movahedi: I’ll start off by going to some things that Chris was saying: that there is obviously the geopolitical situation here and our underlying assumption remains that inflation is probably structural. 

And we’ll need to have higher rates to deal with central bank higher rates, and certainly, the current situation will likely have an impact on the pace and timing of that rate increase, but we’re going to get higher rates. And you know, the traditional business of banking is to buy deposits, if you will, and sell loans and collect the spread. And so, in a rising rate environment, you’re able to raise your price as a bank, in other words, jack up spread on loans, without passing through the rate hikes on what you pay on your deposits. And if you’re able to do that, you improve your spreads. And that’s a good thing, fundamentally. If you take each side of the balance sheet on the lending side, the more variable your loans are, the quicker you will reflect the higher wholesale cost of money. So much of the Canadian banks balance sheets, though, are in residential mortgages, which tend to be more fixed rate in nature, so the re- pricing on the lending side, overall, is likely to be a bit more gradual. 

On the deposit side, the banks are obviously well endowed with retail deposits, our money, your money, my money, etc., the cash sitting in there is not really getting paid a whole lot of rate – 25 basis points or whatever the going rate is. So, those are not really rate sensitive. And so, to varying degrees, they’ll benefit from the phenomenon of not having to pass through central bank rate hikes to the depositors. And so that should be helpful to the spreads. And then I would say more importantly, rising rates usually are indicative of a healthy economy. And banks are, obviously, oftentimes viewed as levered players in the economy. So, that ends up being a net positive. So, there’s no reason to believe a rising rate environment this time around. All else equal will not be good for the bank fundamentals and earnings like it’s been in the past. 

The question really is how much gets priced in to the stock prices? You know, based on our expectations, probably some of that benefit is already reflected in the Canadian banks’ stock prices. But I’ll say, and Chris touched on this as well, there is some funds’ flow dynamics at play in the current environment, especially at the expense of the European banks. Canadian banks are a safe place. They do have very strong reserves, very strong capital ratios, nice dividend yields. And so, right now, a little bit harder to say how much exactly of rate hikes are priced in. There is probably some funds flow benefit in there as well. But the outlook is constructive, for the banks rates are likely going to go up, and that will be a positive. So, we remain constructive, but are probably looking for a more moderate set of returns, like I said, in that 10% or so plus or minus on that one-year basis, versus what we would have been paying attention to, I don’t know, even last time we spoke, certainly six months ago, where you would have expected some significant reweighting as well.

Daniel Stanley: Thanks for that, Sohrab. It seems like there’s a common theme here where we are talking a lot about geopolitical risk. And Chris, geopolitical risk tends to cause volatility. So, I think Chris, this is an opportune time to touch on the subject of options on banks, because the implied volatility of ZEB, our BMO Equal Weight Banks Index ETF, has gone from nine to 16 just in the last six months, and an option contract is ultimately a tool that transforms that volatility from an observable phenomenon into a source of yield. So Chris, can you talk to us a little bit about how this volatility environment is impacting ZWB, which sells options on ZEB and the big banks. And maybe touch on what your outlook is for the coming months? 

Chris Heakes: Yeah, for sure. So, volatility is an interesting aspect how you can actually take that volatility, harness it, and turn it into return. This is something that can be done in a covered call strategy, whereas, obviously, volatility is a bit of a four-letter word, so to speak, when it comes to equities, or even fixed income, corporate spreads sometimes. So that higher volatility environment can actually be beneficial in a cover call overlay. That rise you spoke of from 9% to 16% is actually quite significant when you get into the nuts and bolts of selling call options to increase income. Volatility is the biggest driver of option prices. And what that move corresponds to is, rather than writing options, call it two to 3% out of the money above the current stock price on a one-month basis and collecting maybe 2.5%-3% extra yield, now that transforms to selling them about 5%- 6% out of the money, while collecting that same level of yield, or if not, even a little bit higher. So, what that means, at the end of the day, is more income from the cover call, which we put this overlay on half of the portfolio for ZWB, more income and more upside participation because those strikes are further out of the money. So, I think it’s a good mix, given that banks are relatively close to their highs. 

Often what you see is, as stock prices go up, volatility comes down. When stock prices go down, you almost always see volatility shoot up. But you have this nice dynamic where prices are at pretty good levels, probably think they have the potential to go higher. But they’re near those all-time highs, but we have this high and rich volatility environment, so in any covered call strategy, you want to marry that underlying exposure, and then, also think about what kind of environment is it like to sell cover calls, in this case, constructive on the underlying banks, as I mentioned, a 3.8% dividend yield, just from holding the big six banks equally weighted. And then you marry that with this cover call overlay, where we’re generating an extra targeting, call it an extra 3%, almost doubling the yield of the banks, not quite double, but working towards it. 

And, you know, I think it is an interesting environment, and it’s one that investors can utilize in a market like this. Like I said, it’s possible, and I’m certainly hopeful that the geopolitical risk will decrease certainly not a given, but it’s a potential scenario. But I think we’re still left with interest rate hikes, we’re going to have to have them structurally, as Sohrab mentioned. We’re still going to be left with higher inflation levels to come down and navigate. So, even absent the geopolitics, what I’m saying is, I think there’s a little bit of volatility this year, more than in past years. And I think it can really benefit the covered call approach. And, just as a last point, we’re seeing a lot of flows into ZWB, as well as our mutual fund, which holds ZWB, the Covered Call Canadian Banks Fund. We’re seeing consistent flows, so I think investors are seeing benefits to this approach in this environment.

Daniel Stanley: Thanks very much, Chris. Yeah, there’s no doubt that is a great source of tax efficient income above and beyond the 3% dividend yield. Sohrab, I want to come back to you. You made a comment earlier in this podcast. And in the past, you’ve mentioned that bank capital levels were unheard of, frankly. Banks, as we know, have a couple of ways to deploy that capital: they can either increase dividends’ buy-back stock, they can expand organically, or they can expand via M&A. And, I know, earlier you mentioned that you had a lower target on TD because of some corporate actions. There have been other recent transactions, such as BMO buying Bank of the West, TD buying First Horizon and Scotia upping its stake in its Chilean division, which certainly demonstrates an interest in the ladder use of additional capital. What does the use of M&A by the Canadian banks say about their current financial positions, their overall appetite for risk and how they see the future growth of their businesses?

Sohrab Movahedi: Very good question. And so, just as a reminder for everyone, obviously, coming out of the COVID-19 pandemic, and I’m not trying to call the pandemic over, but certainly the past couple of years did involve quite a bit of reserve-building on the part of the banks, in anticipation of economic weakness and that hasn’t really transpired. And so, they are really emerging with much stronger balance sheets and capital levels. We saw they increased their dividends last quarter, but didn’t change their payout ratio ranges, so they still can continue to target close to half the earnings in dividends, and announced share buybacks. Future dividend increases are probably going to track earnings. Unlike last quarter, where we got some outsides divi bumps really catch up for the couple of years during COVID that they weren’t able to give it. 

But you know, ultimately we believe buybacks are a temporary solution to the banks’ capital solution positions. Shareholders, we think, will eventually frown upon a bank that’s basically capital rich but earnings poor, so capital deployment for the long term will always be a priority. Capital deployment for the long term is likely to involve inorganic opportunities, and on strategy and financially viable acquisitions, should help position what I’ll refer to as ​“hunter banks” to outgrow the ​“farmer” ones. 

As you mentioned, we did have kind of three corporate actions if you will, since we last spoke across the banks. Scotia upped its ownership stake in one of its existing divisions, a nominal deployment of capital, if you will, 10 basis points. It continues to repurchase shares, and we think it’s cheap valuation over there. BMO and TD both kind of did more sizeable acquisitions, but that meant that they ended up suspending, for example, their buybacks. Their acquisitions were largely to enhance scale in the footprint that they’d like to have greater growth in mostly the U.S. In the end, I think acquisitions are going to be part of the solution to the growth equation for the banks. Ultimately, investors, at least fundamentally, want profitable growth, whether it’s organic or otherwise. Time will tell if this latest round of capital deployment will be shareholder accretive, but it definitely comes with the promise of growth above and beyond the nominal GDP level, which is normal course. Otherwise, it’s more competitive market share grabs in your kind of existing markets, which, you know, historically, has been transitory, without any significant wins one way over another income index.

Daniel Stanley: Thanks, Sohrab. Chris, I want to come back to you. Sohrab was talking a little bit about how BMO and TD are looking to the U.S. markets. You know, we typically talk on this podcast about the Canadian banks and the Canadian markets, and this time, we’ve talked a lot about volatility in Canada and its impact on our Covered Call Canadian Banks ETF, ZWB. Chris, can you talk to us a little bit about what’s going on in the United States, as it pertains to volatility and its impact on our Covered Call US Bank ETF – ZWK?

Chris Heakes: Yeah, for sure. And we actually have more, by quantity, of products in the U.S. because we have banks, hedged, unhedged and the covered call, which is unhedged as well. I think, again, where where they are, is, to some extent, as Sohrab mentioned, the higher interest rates, that’s, that’s very beneficial for the U.S. banks. Obviously, absent the geopolitical risk, the U.S. economy is looking pretty strong. You’re seeing a bit of a rotation in the U.S. of value, as opposed to growth, which again, I think favours the banks, makes things a bit more wobbly in the tech sector. But, you know, that’d be getting off topic, but, the banks are looking strong. Despite the volatility, financials in the U.S. are outperforming the S&P, whereas you’re seeing, it is more of a laggard, in recent weeks, last couple of weeks, since this invasion started, certainly interest rates have come down as part of this risk off move, but again, that’s putting a negative, downward pressure on U.S. banks. 

So, again, I think, this volatility environment really does present a good opportunity to sell covered calls. If you look at the volatility profile of the U.S. banks, they’re just a riskier sector than Canadian banks. They trade with more volatility to start with. But when you add in this kind of extra volatility in the market, that number we talked about, ZEB going from nine to 16, in the U.S., that number’s more like gone from 25 to 40, just to give you a relative perspective. I think a lot of investors don’t need a huge position in U.S. banks, but if you do, just keep in mind that it’s a higher volatile exposure, but, you know, a little bit of it can go a long way. And when we’re selling options on those U.S. banks, we’ll be selling options 10% to 15% out of the money, and we’ll be collecting high level of yield, probably closer to 5% yield on those. So, it’s an attractive backdrop from that perspective. And again, I think we’re relatively constructive on markets as we navigate these geopolitical risks, and we look forward to what’s happening with the interest rate hiking. We think it’s a good backdrop for U.S. banks. So again, looking pretty attractive in the U.S. sector/U.S. region and ZWK is a good tool to get exposure to a diversified, equal-weight basket of U.S. banks, and also to have that extra income from the option overlays. So that product’s yielding a net 6.8% as of taping.

Daniel Stanley: Chris and Sohrab, thank you guys both very much. I really appreciate your insights on these issues. I’ve jotted down a couple of things that I think are some key insights to take away. Chris, from you, at the end of the day, we’re in a highly volatile environment, which creates opportunities to sell call options and, in effect, monetize volatility. On that backdrop, though, and, Sohrab, this comes to a takeaway from you that, at the end of the day, the banks are having a solid start to the year. And in fact, the expectations into the future are for high, single-digit returns with dividends that continue to be very attractive. 

So, 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 ETF ZUB and ZBK, or the Covered Call U.S. Banks ETF, ZWK, the one that Chris was just mentioning. If you have any questions, please visit our ETF dashboard at BMO etfs.ca for research news and insights. That’s all for today, folks, thank you for tuning in. Please join us next time for our next update on Canadian banks.