Big Six on a big run

Earnings season will test rally

A year ago, slumping commodity prices and fears of a housing bubble were casting a shadow over Canada’s biggest banks.

Bearish analysts slashed target prices and estimates, and noted positive earnings growth over the next year would be unlikely.

As the old saying goes, hindsight is 20-20.

What followed instead was one of the strongest 12-month rallies by big Canadian banks in recent memory.

In the “exceptional” run since last Feb. 17 — when the stock market was still languishing following a January sell-off — shares of Canada’s Big Six are up an average of 37 per cent, including a gain of more than 17 per cent since the U.S. election on Nov. 8.

National Bank has seen the largest one-year jump at nearly 52 per cent, while Scotiabank leads the Big Five with a gain of more than 45 per cent.

The gains are thanks in part to recovering oil prices and a more optimistic outlook for the economy (and for banks in general) since Donald Trump’s election, as the new U.S. president pushes to cut both corporate taxes and regulation.

But as the banks begin to report their first quarter results this week, investors will be watching closely to see if earnings will match the optimism fuelling the rally.

“Talk of deregulation and rising interest rates (this part isn’t just talk) have propelled bank stocks to all-time highs,” said CIBC Capital Markets analyst Robert Sedran in a note to clients on Feb. 14. “At the very least, the banks have shown that they can grow earnings as projected in a less-thanideal environment and the operating environment looks poised to improve.”

Earnings season officially kicks off on Thursday, with the Canadian Imperial Bank of Commerce being first to report its first-quarter 2017 results.

Despite a difficult backdrop, Canada’s banks beat expectations with earnings growth of four per cent last year, said Sedran.

The Canadian banks’ valuations have also been helped by their exceptionally strong dividend track records and the relatively safe investment they offer, said John Aiken, an analyst at Barclays Capital in Toronto.

“They’re not immune to pressure, but they definitely have a greater level of stability on their earnings and outlook than most of their global competitors,” Aiken said in an interview. “And within that context, that becomes a very compelling investment thesis at times where there is volatility and uncertainty.”

While the outlook isn’t quite “sunshine and lollipops,” “there is reason to be optimistic about bank results” heading into Q1 reporting, said Meny Grauman, a bank analyst at Cormark Securities Inc. in Toronto.

This optimistic view is driven by an improving macro-economic outlook, particularly the gains in the Canadian labour market, which has “clear and positive implications” for several key bank earnings drivers, such as loan growth and domestic loan loss provisions, Grauman said in a note to clients on Feb 13.

Cormark expects Canada’s largest lenders to post a seven per cent earnings-per-share growth, on average, with Bank of Nova Scotia due to see the highest jump at 11 per cent.

“Even after the rally in the shares that we saw in the second half of 2016, we still believe that Street expectations are setting the bar low enough for the group to once again handily beat expectations,” Grauman said.

However, while investors are excited about an earnings acceleration for banks south of the border — including for the U.S. units of the Canadian banks — Grauman believes that has already been priced into relevant stocks.

In 2016, the Big Six banks’ saw their forward price-earnings ratios rise by a steep 31 per cent, said Mario Mendonca, a bank analyst at TD Securities Inc. in Toronto.

“Over the last 16 years, there have only been two other years when multiples expanded by more than 25 per cent — 2009 (following the financial crisis) and 2003 (following the tech/telecom bubble),” he said in the note on Feb. 6.

Talk of deregulation and rising interest rates (this part isn’t just talk) have propelled bank stocks to all-time highs.

This “exceptional” share price performance typically comes after valuations have been “beaten up,” Aiken said.

Now, with some of the pressure off the banks, there is very little multiple expansion left, he added.

“We think the valuations are running too far ahead of themselves,” he said. “And that it does look like the market is pricing in stronger growth than what can realistically be obtained in an economic environment where the Canadian economy is going to grow somewhere between one and two per cent.”