Forecast of lacklustre earnings could warrant more cautious stance on banks
Headwinds may include housing, changes for loan loss, Jonathan Ratner writes.
It’s been a pretty good year for Canadian bank stocks. The S&P/TSX Composite Banks Index is up more than 14 per cent in 2017, outpacing the broader equity market by a healthy margin, with the majority of those gains coming since early September.
But with what looks to be a lacklustre round of fourth quarter earnings beginning next week, is it time for investors to take heed of warnings about the Canadian housing market and reduce their exposure to bank stocks?
When it comes to loan losses, there is plenty of reason for optimism. Strong employment and economic growth trends have helped loan losses for Canada’s big banks return to trough levels, after two years of weakness in the oil market caused plenty of pressure.
While credit has been a modest positive for the banks this year, CIBC World Markets analyst Robert Sedran warned that uncertainty is on the horizon.
“Arguably the most interesting angle for credit this quarter will not be the actual numbers, but the disclosure for IFRS 9,” he told clients.
The IFRS 9 accounting change, which takes effect on Jan. 1, will alter the way Canadian banks reserve for loan losses. While it’s unclear what impact this will have on banks and their share prices, Sedran noted that the group is now trading above the mid-point of its valuation range, and that creates more risk until the market has an opportunity to digest the change.
“We see a mild tailwind from interest rates offsetting the anticipated slowdown in personal loan growth, particularly as regulatory changes have an impact on the mortgage market,” the analyst said.
Investors and the banks themselves will also have to grapple with the new OSFI B-20 Guideline that forces Canadian mortgage lenders to “stress test” home buyers who do not need mortgage insurance at much higher rates. The agency estimates that this group accounts for 55 per cent of the banks’ residential loan books.
Matthew Barasch, Canadian Equity Strategist at RBC Capital Markets, noted that these upcoming changes to mortgage qualification rules, will essentially reduce qualification levels by approximately 20 per cent, and therefore present an interesting test case for the Canadian housing market.
Barasch thinks concerns about Canadian housing are overblown, but he also believes that when put together, high consumer debt levels, changes to credit loss reserves, and these mortgage changes, warrant a more cautious stance on banks until they are at least partly digested.
Guillaume Arseneau and Martin Roberge at Canaccord Genuity expect the new mortgage lending rules, which follow similar measures implemented in late 2016, will set in motion the long-awaited housing market correction next year. The analysts believe the Toronto and Vancouver markets will bear the brunt of the home price downturn, but other regions will see spillover effects.
They estimate all of the regulatory changes will boost the gross debt service ratio (used by lenders to assess the financial health of potential borrowers) in Canada by about 20 per cent. Canaccord also forecasts an approximate 17 per cent decline in the buying power of prospective home buyers.
“Admittedly, severe housing price corrections are rare occurrences in Canada,” Arseneau and Roberge said in a report, noting that mortgage lending only contracted once, during the 1982 economic recession.
“Through a typical correction, lower housing prices, falling bond yields and lower mortgage rates would eventually restore affordability, allowing bargain hunters to step in and stimulate banks’ mortgage lending business,” the analysts said. “This time around, we believe the fundamental backdrop is different.”
Not only do they view bonds as very overvalued, but the analysts see little reason for yields to decline given the renewed synchronization of global economic growth. Meanwhile, higher qualifying rates for mortgages and other restrictions are “sticky” and should therefore keep access to mortgage financing tighter.
“Our view is that bargain hunters are likely to stay on the sidelines unless home prices decline markedly to restore affordability and supply/demand forces,” they said.
Canaccord forecasts an eight per cent decline in Canadian mortgage lending next year, with total bank lending expected to fall about two per cent. That implies earnings growth for the banks of approximately three per cent, compared to 5.4 per cent average growth projected by bank analysts.
Scotiabank kicks things off on Tuesday, followed by Royal Bank of Canada the next day, CIBC and Toronto-Dominion Bank on Thursday, and National Bank of Canada on Friday. Bank of Montreal, Laurentian Bank and Canadian Western Bank wrap things up the following week.