Strategists and analysts at Scotiabank are bullish on Canadian bank stocks, but only for the short term and primarily as a bet against another financial sector: life insurance. Longer term, the unwinding of the domestic debt bubble and rising funding costs are expected to limit returns from the banks.
Meny Grauman, Scotiabank’s bank analyst, and the strategy team led by Hugo Ste-Marie jointly published a report this week with the seemingly optimistic title After Months of Underperformance, Momentum Builds for Canadian Banks. The premise is that stock price and earnings momentum has bottomed and that the potential end of interest rate hikes will cause a rebound.
Banks generate profit on loans by borrowing funds at short term rates and lending them to clients at longer term rates. The current environment, where the Bank of Canada has pushed short-term rates higher but longer-term rates have barely budged, has detracted from profit growth. The end of rate hikes, according to Scotiabank, will prove a catalyst for bank stock prices.
The banks have marginally underperformed the broader S&P/TSX Composite Index in 2023 but hugely underperformed life insurance stocks – by two standard deviations relative to history. “Hence, odds of a bank rally relative to insurers is much higher. These rallies are not necessarily the start of a long-term trade, but should be seen as tactical retracement from oversold conditions,” the research report argued.
Mr. Ste-Marie and Mr. Grauman believe short-term rates, and thus bank financing costs, will remain elevated in the coming years. In addition, the debt-ridden consumer balance sheets in Canada combined with rising loan rates will force banks to build funds against potential losses and bankruptcies. These provisions against credit losses (PCLs) are subtracted directly’ from earnings.
The two trends of higher short-term rates and deteriorating credit conditions will cap longer-term earnings growth and performance for the banks, according to Scotiabank.
The most direct application of this research report is for hedge fund managers to cheaply put on a ‘short lifecos/long banks trade’ using derivatives. For the average investor, however, the takeaways are less clear even if banks are arguably the most important sector of the TSX.
It might be time for investors to keep an open mind where bank stocks are concerned. There hasn’t been a bad time to buy bank stocks for most of our investing lives and no sensible person would suggest completely avoiding them now. But to some extent we are in a new market environment, one of rising instead of falling borrowing costs, and blind faith in the sector is misplaced.
-- Scott Barlow, Globe and Mail market strategist
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Compiled by Globe Investor Staff