Real estate uncertainty, looming capital regulation hanging over bank stocks
Solid third quarter earnings and even better year-to-date results, coupled with a lacklustre share price performance so far in 2017, have Canadian bank stocks looking like pretty good value these days. That has some investors looking forward to a rally in the near future, but a few issues might need to be sorted out before that happens.
Darko Mihelic, a Toronto-based analyst at RBC Capital Markets, is among those that believe the banks are close to being “undervalued.”
However, regulatory and accounting changes, the Bank of Canada’s plans for interest rates, and a Federal investigation into sales practices at the banks, are standing in the way of bullish bets on the sector. Then, of course, there are questions about the stability of the Canadian housing market.
While real estate worries are probably the biggest overhang for bank stocks at the moment, signs are emerging that the pullback in housing prices and activity has levelled off.
RBC estimates that residential real estate-related activity could account for as much as 25 per cent of the Canadian economy, while regulatory changes over the past year should lead to slower domestic mortgage growth.
However, Mihelic isn’t worried about credit quality at the banks. Instead, he believes rate hikes and other changes, could cause an indirect hit on the Canadian economy and bank earnings. Yet he reminded clients that recent year-over-year domestic mortgage growth has remained near five per cent on average for Canada’s biggest banks — much better than anticipated.
An issue that may be overshadowed by the housing market is the regulatory uncertainty potentially impacting banks in terms of capital.
“It is unclear when and how Basel IV may be implemented for the Canadian banks,” Mihelic said, adding that the adoption of IFRS 9 may result in balance sheet adjustments that impact capital ratios in the sector.
He anticipates a significant increase in provisions for credit losses in 2018 and 2019 as a result of IFRS 9, which will be adopted by the banks beginning in the first quarter of 2018. However, the improving Canadian economy is expected to have a positive impact on PCLs.
While household debt levels relative to personal disposable income continues to rise, RBC doesn’t think that will deter the Bank of Canada from another 100 basis points or more of interest rate increases. Further hikes should support net interest margins for the banks.
“Historically, Canadian bank valuations have been more correlated with fundamental improvements (e.g. ROE improvement) rather than changes in interest rates,” the analyst said.
He prefers National Bank of Canada and Bank of Nova Scotia, noting that both have strong capital positions and have made efficiency gains.
“We view National’s good position to increasingly return capital to shareholders and Scotiabank’s international loan growth improvement positively,” Mihelic said.
Historically, Canadian bank valuations have been more correlated with fundamental improvements ... rather than changes in interest rates.