Where U.S. banks go, Canadian banks may follow.
That’s becoming a pressing concern after U.S. banking giant JPMorgan Chase & Co. this week reported a sharp drop in its quarterly profit, warned of potential economic challenges ahead and watched its share price decline to 15-month lows.
U.S. banks were solid performers during the early stages of the economic recovery in 2020 and 2021, as loan losses subsided, employment levels rebounded, trading activity surged and deal-making boomed.
But their share prices have been sliding over the past six months amid concerns that rising interest rates could tip the economy into recession. JPMorgan’s share price has fallen 20 per cent this year, underperforming the S&P 500 by 13 percentage points.
That poor performance raises the question of whether Canadian bank stocks – off their February highs but down less than 1 per cent this year, on average – will follow the U.S. lead.
In many ways, the backdrop for North American banks looks attractive right now: The housing market is strong, credit-card spending is surging and the U.S. unemployment rate has fallen to 2019 levels.
What’s more, central banks have begun to raise interest rates, which should make lending more profitable for banks and add a powerful tailwind to their earnings.
However, some bank executives and analysts have turned cautious about the future – Jamie Dimon, JPMorgan’s chief executive officer, being one of them.
Mr. Dimon warned in a recent letter to shareholders that the confluence of economic stimulus during the pandemic, the need to raise interest rates and the war in Ukraine “may dramatically increase the risks ahead.”
In separate commentary that accompanied the bank’s financial results this week, he reminded shareholders that the road was anything but clear.
“We remain optimistic on the economy, at least for the short term – consumer and business balance sheets as well as consumer spending remain at healthy levels – but see significant geopolitical and economic challenges ahead due to high inflation, supply chain issues and the war in Ukraine,” Mr. Dimon said.
These aren’t idle thoughts. The bank surprised analysts by setting aside US$902-million during its most recent quarter, as a cushion against the threat of rising loan losses in the United States and repercussions from sanctions against Russia.
Its profit for the quarter fell 42 per cent from last year. Other U.S. banking giants reported similar declines. Profit at Citigroup Inc. fell 46 per cent, Goldman Sachs Group Inc. fell 42 per cent and Wells Fargo & Co. fell 21 per cent, weighed down in some cases by declining mortgage originations and investment banking fees.
Can Canadian banks, which will report their quarterly results in May, coast as their U.S. peers struggle? Some analysts are starting to wonder.
“Canadian bank stocks are not being priced for the same economic risks that have already been incorporated into the bond market and U.S. bank stocks,” Paul Holden, an analyst at CIBC Capital Markets, said in a note this week.
For example, he pointed out that price-to-earnings ratios for Canadian banks are just 4 per cent below comparable ratios for U.S. banks. The historical average is a discount of 16 per cent.
And he calculated that Canadian bank stocks trade at 1.8 times their book value. That is slightly above the historical average of 1.7, despite what he sees as mounting economic risks related to rising interest rates.
“Central banks will attempt to thread the needle, balancing the need to tame inflation without tipping the economy into recession. While we have no doubt central bank intentions will be the right ones, we do have to contemplate the possibilities for error on either side of ‘just right,’” Mr. Holden said.
He expects that loan growth will slow to 5 per cent in 2023 from 10-per-cent growth this year. But if central banks raise rates too aggressively, triggering a recession, he thinks loan balances could contract by 4 per cent as indebted consumers face pressures.
In a recession, Canadian bank stocks could slide 30 per cent, he believes. That’s why he recommends shifting to lower-risk banks, such as Royal Bank of Canada and National Bank of Canada, which have higher cash buffers and more diversified profits.
Canadian bank stocks have outperformed U.S. bank stocks this year. But the winning times might not last.
Full disclosure: The author owns units in the BMO Equal Weight Banks Index ETF.
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David Berman