Canadian big bank stocks have tumbled more than 14 per cent over the past three months, as concerns about an oncoming recession rattle equity markets. The potential rewards of buying into this dip are becoming hard to ignore.
The sector hit its peak in early February, when a number of factors lined up nicely for lenders.
The Canadian economy was performing well, unemployment was falling and the housing market was hot.
The Bank of Canada was laying the groundwork for raising interest rates – good news for banks because higher rates generate fatter profit margins on loans.
And the banks were again raising their quarterly dividends, launching share buybacks and announcing cross-border acquisitions, ending a lengthy hiatus on these activities during the worst of the pandemic.
Everything seemed almost normal, and investors like normal: Bank stocks cruised to record highs in early February.
Now, though, central banks are getting aggressive with rate hikes in an effort to tackle the highest level of inflation in four decades, raising concerns that rising rates will tip the economy into recession.
These concerns are showing up in the broader market.
The S&P 500 is down 16 per cent in 2022. The four months through the end of April marked the index’s worst start to a year since 1939, and market turbulence has defined much of May.
“The persistence of inflation has driven a sharp reversal in sentiment, from hope to fear,” Susan Roth Katzke, a U.S. banking analyst at Credit Suisse, said in a note this week.
Recessions can be especially harsh for bank stocks, no doubt pushing some investors to bail out ahead of any ugly economic surprises.
We outlined the risks here a few weeks ago. Now, amid greater gloom and lower stock prices, it may be time to look at the upside: There’s no guarantee that a recession will emerge, nor is there any certainty that bank stocks will continue to slide.
Ms. Katzke expects that large U.S. banks – whose share prices are down about 20 per cent this year – can potentially return more than 20 per cent over the next 12 months, with dividends.
Her argument: Bank profits are resilient, balance sheets are in good shape, valuations are low, and she has greater confidence in the economy staying out of recession until 2025.
The case for Canadian bank stocks is based on similar reasons.
They are in good financial shape, with capital buffers well above minimum thresholds set by the banking regulator. They can easily withstand rising loan losses.
“While the recent market volatility has tested the banks’ reputation as a ‘relative safe place to hide,’ we believe the banks have strong capital and reserve levels to weather the storm,” John Aiken, an analyst at Barclays, said in a note.
Valuations are low, suggesting that a lot of bad news is already priced in.
According to RBC Dominion Securities, bank stocks trade at just 8.6 times estimated 2023 earnings. That is well below the 15-year average price-to-earnings ratio of 10.8.
As for the threat from a housing meltdown, bank analysts expect mortgage growth to slow from the hectic pace during much of the pandemic rather than collapse. The consensus forecast for 2023 is for mortgage growth of 7 per cent, down from expected growth of 10 per cent in 2022.
Even if growth were cut in half, to 5 per cent, the impact would be modest: The difference would shave 0.3 per cent from bank revenues, according to Gabriel Dechaine, an analyst at National Bank of Canada.
He pointed out that the last time mortgage growth slowed considerably was when regulators introduced stringent underwriting standards, in 2012 and 2018.
Then, bank stocks underperformed the S&P/TSX Composite Index. But in one case, the underperformance occurred before changes; in the other case, after the change.
“Given the lack of consistency, we cannot ascribe relative performance solely to mortgage market dynamics,” Mr. Dechaine said in a note.
That’s why investors should consider those big dividends instead.
The average yield climbed to 4.3 per cent this week, as share prices fell. Yields could rise more if banks announce dividend increases with their fiscal second-quarter results, starting May 25.
“With no change in dividend policies in the first quarter, we expect a bonanza of dividend hikes,” Mr. Aiken said.
No doubt, a better buying opportunity might arrive later if markets remain volatile. But there’s a pretty good buying opportunity today.
Full disclosure: The author owns units in the BMO Equal Weight Banks Index ETF.
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