This podcast was published on December 72021

Daniel Stanley: Welcome to the fifth episode of our deep dive series on Canadian bank quarterly earnings. Today we’re covering the fourth quarter 2021 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 the most equity and multi-faceted 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 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. And let’s get started. And I want to start things a little bit differently today, Chris and Sarah, because I took the liberty to look at the comments that you both made on our very first Canadian bank podcast, which was recorded almost exactly one year ago. Happy anniversary. Sohrab, I want to start with you. Because one year ago, you said and I quote, It was an interesting end to a challenging quarter.” Can you share with the audience how the banks did in the recent quarter? And how does it compare to this time last year?

Sohrab Movahedi: Yeah, thanks. You know, I’ll start off by saying they always tell you that the key to a happy life is low expectations. So, I think coming out of last year, we had our expectations reset going into this quarter. When you look at our expectations, and I’m here I’m talking about BMO Capital Markets’ expectations for the Canadian banks. The fourth quarter results actually all exceeded our expectations. I will say, though, that CIBC, Royal, and National fell a bit shy of expectations.

Relative to our expectations, I think it was a continued narrative of good credit performance. That would have been a key contributor to the beats. And I’ll say that, really, all but two of the banks have reported net recovery positions on the provision for credit line on the income statement, so that is incredibly rare. I’ve looked back 20 years. I think it’s happened for some of the banks once, and it’s a reflection of, obviously, excessive reserve building, with the benefit of hindsight. Some tailwinds continue as far as the credit for next year, but there’s going to be some degree of normalisation, which is another way of saying don’t be worried about credit, but don’t expect to have recoveries going forward. So, there will be a little bit of a headwind on that line probably for some of these banks. 

And you know, the capital levels as source of or thermometer if you will, on balance sheet strength remain very strong – up year- over-year. TD Bank remains the capital leader. The CET 1 regulatory common ratio over there is 15.2%. Honestly, for Canadian banks, literally unheard of probably. If you go back 10 years, it would have been mid-single digits. I mean, 15.2%, obviously very well capitalised. Now that would be an extreme from a TD perspective, but all of the banks are probably comfortably ahead of regulatory minimums. We updated our 2022 expectations from an EPS perspective for all of the banks, and I’d say coming out of this year going into next year, we would characterise flat is the new up as far as bank earnings are concerned, because we think that, like I said, there will be some normalisation.

On the credit line, that is a headwind, but that will be offset by the by the tailwinds of improving top-line growth largely on the back of expectations of higher interest rates and net interest margin. So, a better quality earnings, I guess, insofar as it will not be a credit-driven year, but all the same, will probably keep earnings at bay, compared to this year. And then as the market starts shifting focus to the 2023 earnings, we rolled out our estimates for them. And, you know, basically expect the banks to get to, within their medium-term EPS growth targets of 5-10%. So, all in all, I would say, a good a satisfying end, I guess, this year, with a bit of a constructive outlook into 2022 and beyond into 2023.

Daniel Stanley: Thanks very much, Sohrab. I appreciate that insight. Chris, over to you. A year ago, and you said, and I quote here that banks are an anchor in Canada.” How does the recent experience over the last year either reinforce that idea, or maybe even weaken that idea? Can you comment on that? 

Chris Heakes: Yeah, for sure. Thanks, Dan. First of all, I’m not sure exactly what I meant by that at the time, you know, I can barely remember sometimes what I said last week, but I think I think where that comment came from, and it’s certainly been reinforced by the past year, banks are the bellwether of the Canadian economy. As the economy goes, so does the banks, the banks have their ties deep through all components of the Canadian economy in the Canadian market – 20% of the TSX composite index. And that tends to be a pretty stable unit of the index, whereas you’ve seen over the past year, say, energy weights go up and down, or material weights go up and down, the banks are always there. So, an anchor from that perspective. 

I think the other the other kind of way of looking at that statement that I think resonates is just how anchored from an investment point of view, and how accretive of an investment they’ve been for Canadians over the years. They have this very long-term track record of outperformance, versus the index, and also an anchor from the sense of quality. And we’ve seen how powerful quality investing can be on our side. We talk about it all the time, Dan, right, in our ETF discussions, but very high-quality, diversified businesses that are well run. And I think it’s really been reinforced over the past year. I think we were always generally constructive on that, that recovery from COVID, from the beginning,g was going to take some time. We needed vaccines. So, you’re right, it was a year ago, we kind of had that first vaccine push. But banks weathered the storm. So, Sohrab said, incredibly well capitalized in Canada and now perhaps to an all-time record, it sounds like. 

But you know, banks took their lumps during early COVID. They were down, but now we’re coming off a year of 40%+ returns. You know, one thing we look at is just, personally, the BMO returns on a 1,3, 5 and 10-year basis, and BMO (ZEB) is beating all those metrics now. So, I think that comment certainly is still holding true – that they’re an anchor, and, you know, it’s something I think investors can lean into. 

Daniel Stanley: Thanks, Chris. That’s a great segue into my next question, Sohrab, for you, because Chris sort of alluded to the point of the banks being an anchor to Canadian investors from an investment perspective, and Sohrab, we know that the dividend increases and share buybacks, why the amounts weren’t known ahead of time. Certainly, it was well telegraphed in advance that this was likely going to happen after the regulators allowed it to. What I found interesting was that the media was very hyperbolic about it. They you know, there was a headline from one of the newspapers that said, Canadian banks expected to unleash dividend growth tsunami next week.” So, Sohrab, my question for you is, was this a tsunami,” like the headline said? And, were there any surprises out there when it came to dividend increases and share buybacks?

Sohrab Movahedi: I’ll go back to how I started the first one, and I’d say I guess the key to a happy life is low expectations. So, the dividend increases certainly would look like a tsunami, relative to our expectations. They generally came in double the growth that we were looking for, led by BMO – 25% dividend increase – that would have been the high, National Bank at around 23%. But, quite honestly, the rest of them, TD, Royal, Scotia, CIBC, all in the 10-13% range. So, that is obviously a big statement on the part of the bank management teams around their earnings growth outlooks for their franchises, but it’s also a catch up, if you will, to reflect the missed increases last year, which was impacted by the moratorium the regulator had put on around dividend increases with respect to buybacks. I think we may have even talked about it on this podcast in the past – the buybacks actually, in a couple of instances, would have been a little bit higher than what we were looking for. We were generally looking for a 2% NCIB-type share buyback programme. I think a couple of the banks actually went up, home team here, BMO went up 3.5%, a couple of the other ones at around 3%, so call it 2-3.5% range. 

And I would characterize that, number one, we like it. But number two, is it going to be executed on? Are they going to actually complete these programs, as opposed to just having them as a placeholder? That is going to be an important indicator. We expect a bank, like Scotia Bank, like TD, will probably complete the program. Some of the other banks may not, because they’re less inclined to return the capital, but they may have a better place to redeploy that capital, relative to where their stock is trading. So, I would say, buybacks as or slightly ahead of expectations, dividends, certainly ahead of our expectations, and remember that most of the Canadian banks tend to review their dividends semi annually. So, we would expect, you know, at some stage – call it over the next couple of quarters, when they report their second quarter results for 2022 – maybe we’ll see some other bumps, but I would suspect those ones would be a lot more measured relative to their earnings growth prospects, as opposed to the catch up that we got over here. 

Last thing I’d say is there was no shift in the dividend payout ratio targets for the banks. So, they continue to target that 40-50% range, and so, we think had the kind of capital levels, they have the kind of earnings they’re generating, the kind of ROI ease that delivering on those earnings, or on their equity, I suppose, is quite supportive of continued dividend increases there. Let’s call it the track record to stay intact, as far as continuing to pay the dividends and increase it, and we would be more on the cap on the buybacks, instead of getting a year of a 5% or 6% buyback, it would be very Canadian-like to have two or three years of 2-3% buyback, so we expect that could be a gentle tailwind for earnings per share going into 2023 and hopefully beyond is wrong.

Daniel Stanley: Thanks. That’s a great tie in to what Chris was saying – that from an investment perspective, the Canadian banks being an anchor and it’s great to hear that given their capital level, their earnings, that it does support dividend increases for the future, given how Canadian banks are such an anchor for Canadian investors and they look to that dividend as a key part of their total return.

Chris, I want to come back to you. ZEB, which is the Canadian Equal Weight Banks Index ETF. It was up roughly three to 4% in just that one-month period between mid-October and mid-November. There still seems to be a lot of uncertainty globally with the pandemic, the supply pending issues, can you tell us what’s driving a positive sentiment in the banks right now? And do you see any headwinds for that going forward?

Chris Heakes: Yeah, thanks. I think it’s been a been an exciting month or six weeks or so. You know, certainly we, I think we all get a little excited around bank earnings, because it gives you that read on what’s happening in markets and maybe a direction forward. I think anticipation around these earnings, in particular, with the focus on those potential dividend increases, certainly, were top-of-mind investors. 

It was early November that OSFI gave that relief to that temporary prohibition to increase dividends or buybacks, stocks that came in early November, that certainly fueled some of the positive sentiment. The real kind of curveball, obviously, I think, was the Omicron variant hitting the market in late November, and as we go to go to taping, today and early December, we don’t know exactly how big of an issue it is, but it looks like the early indications are that, although it may be transmissible, it’s not as virulent or as potent a virus as maybe some of the earlier variants. 

So, I think that’s been the short-term news, and what that allows ZEB and the market as a whole, is to correct back to that path it was on pre- the Omicron news. So that’s what we’re seeing, assuming those concerns can abate on the Omicron side, we’re seeing ZEB trade back towards the level it was pre-Omicron. They can get back to the fundamental strength, and participate in some of those dynamics that Sohrab was speaking about and potentially continuing on that path of dividend increases again into next year, maybe not as big as ones we had this quarter, but continuing on those positive trends of economic strength, of managing to get through this crisis. 

So, as investors look forward, there’s a lot of positive sentiment, and from an income point of view, do you want income as an investor. The equity market is actually a pretty attractive place to get that now. Obviously, you always have to manage your asset allocation, but with banks yielding kind of closer towards 4% now, it’s an attractive place to be where we’re fixed income yields are, are still low for the time being. So, the tailwinds are there. So, to continue on the analogy of the ship, it has the anchor, and the tailwinds are there. And I think, as investors get more comfortable with this new variant, we’re seeing that positivity back into the underlying stocks.

Daniel Stanley: Thanks for that, Chris. Sohrab, I want to move back to you. Chris sort of alluded to one curveball, which was Omicron. The other curveball was the suggestion that there would be a new surcharge on financial institution profits over a billion dollars. I think that came out publicly back at the end of the summer. There was the suggestion recently that it could be pushed through by Ottawa as soon as the start of 2022. Just curious, at a high level, how investors sort of should approach this concern at this point in time?

Sohrab Movahedi: Yeah, it’s a hard one to have very good clarity or visibility on, but I will say that there is no doubt that the banks benefited, and I’m here I’m talking about Canadian banks, but probably banks globally, with their respective kind of governments benefited from the government support programmes insofar as it allowed the economy to continue to perform, obviously, at a reduced level, but continue to perform. You look at what has happened since the trough, I mean, the banks have kind of come back, and the earnings have kind of stayed intact. And part of the reason why we’re getting these credit recoveries is because of some of the government support programmes that were introduced in response to COVID. So, I don’t think the banks, I mean I can’t speak for the banks, I don’t think even banks see any issue with contributing to the recovery. I think the issue is whether or not it makes sense to either isolate one specific industry, that’s going to be I guess, the politicians’ call on this and, number two, whether or not going at some sort of surcharge tax on the banks, would it be, I suppose, in a way expropriating shareholders money?

But, I think the banks will proceed and deal with this thing in a Canadian way. I think they understand the regulator understands, and probably the legislator understands that it has to be a solution that works for everyone. And usually, the way the solution has worked in Canada is, whatever the outcome, as far as a surcharge or a tax, or a headwind for the banks, it has been something that has been layered in with the benefit of time. And when you have that, then, obviously, banks and bank management teams and investors and market participants have sufficient time to react to it. 

So therefore, there might be a bit of a bump in the effective tax rate here. I will say, though, that if you had told me – you pick it, four years ago, two years ago, three years ago – that the Canadian banks would continue to give you a resilient, mid- to high-teens return on equity, even as their capital levels may double, or go up by 50%, I would have said I don’t see that’s possible, but they have proven that they can. So, on the one hand, I think we need to take the Liberal tax, and or any other surcharges within reason seriously, but I think on the other hand, if we look back to history, we’ll see that with the benefit of time, the banks have actually been able to continue to deliver shareholder-friendly returns, not withstanding some of these headwinds.

Daniel Stanley: That’s great, Sohrab. Thank you for that. Chris, I’m going to come back to you. And I want to go back to a point that Sohrab made. He said that flat is the new up.” So, Chris, if we take that comment over to the performance of the Canadian banks. Let’s hypothetically say that the Canadian banks start to trade sideways instead of the upward motion that they’ve had, over the last couple of years, what other solutions are available to generate return in a flat market?

Chris Heakes: Yeah, thanks, Dan. And obviously, this is where our covered call overlay can add some value for investors. So ZWB is our equal weight, covered call Canadian Banks strategy, really designed for income, a couple of use cases, but income-oriented investors; for investors who want a little bit less risk, because the covered call will tend to reduce risk a bit, or like you say, could be for tactical investors who just expect a less outright bullish market, the covered call can potentially add value in that market. What we’re doing with those covered call overlays is selling covered calls. So, the selling up a portion of potential upside in return for current income. And it’s really that income – that extra, call it, 3% a year on the Canadian banks in income coming from the options – that can give you that kind of risk reduction, little benefit, and also gives you the ability to outperform in sideways markets. 

So, overall, I’d say it’s a conducive market to cover call strategies right now. One of the things that helps you generate income efficiently is actually volatility. And we’re seeing a little bit more volatility in the market, not only with Omicron, but I think around central bank policy, and maybe we’ll talk about this on the next call, but central bank policy and potentially increasing rates into next year. But, that volatility backdrop can actually be beneficial for the cover call overlay, and, again, today can be a very useful tool for investors who perhaps have that tactical view on a less bullish market, or simply investors who have that need for income, or wanted to take a little bit less risk off the table. 

So, you know, our ZWB fielding right now 5.6% net, so obviously, much about the underlying yield of the banks, but with that extra yield from the cover call option. And one thing to be a little bit excited about for our ETF investors is the potential for that to increase because, Dan, as you know, we haven’t reset our dividend yields on our ETFs yet to reflect the dividend increases that just came through the Canadian banks. So, potential for a little bit of increasing good news story there as well for ETF investors. But yeah, very valuable tool, if that’s the approach you would like to take.

Daniel Stanley: Thanks, Chris. And Chris and Sohrab, thank you both. I’ve jotted down a couple of things that I think are some of the key insights. And first of all, Chris, I agree with you 100%, I think next call, let’s have a quick discussion on central bank policy, given the changes that are going on.

Sohrab, I loved the comment that you made about the fact that the banks are sort of getting mid- to high-teens return on equity with capital levels that are up sort of 50% range, that you thought it wouldn’t be possible, but the fact is they’re proving us otherwise. I think that’s a really important take-home. 

Chris, the take home from you is the fact that the equity market is still a great place to get income. When you look at ZEB, the yield of 4%, versus bond yields – a significant difference there. And then, your last point that we actually haven’t adjusted those dividends yet in ZEB. Those dividend increases will be reflected shortly. 

As a reminder to the audience, you can get exposure to the Canadian banks via ZEB, ZCN and ZWB. All ETFs trade actively on the TSX. You can get exposure to U.S. banks by a ZUB and ZBK, or the Covered Call US Banks ETF, ZWK. If you have any questions, please visit our ETF Dashboard at for research, news and insights. That’s all for today, folks. Thank you for tuning in. Please join us in mid-March for the next update on Canadian banks.