Soft-landing bets fuel Canadian bank stocks despite real estate worries – Financial Post

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Investors have actually made a small profit so far in 2023

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Canada’s economy is stalling, the unemployment rate is rising and housing costs are crushing some households. The country’s banks are exposed to all of that, yet their shares are surging.

A major index of Canadian bank stocks is up 11 per cent since the beginning of November, erasing most of the year’s earlier losses. Including dividends, investors have made a small profit so far in 2023, in contrast to the KBW bank index of U.S. lenders, which is still in the red.

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The rally is a bet on a softer economic landing in 2024, one in which bank profits won’t be badly damaged by the financial squeeze that’s hitting Canadian households because of mortgage-rate resets and higher rents.

For the Big Six banks, earnings per share dropped more than six per cent, on an adjusted basis, in the fiscal year that ended Oct. 31. They’re expected to decline an average of 1.1 per cent in the current fiscal year, according to analyst forecasts compiled by Bloomberg.

Canadian bank valuations

“The earnings are going to struggle to grow over the next year or two,” said Murray Leith, director of investment research at Odlum Brown Ltd., a Vancouver-based firm that manages about $18 billion. “But they’re very profitable businesses, so there’s a lot of things they can do to add shareholder value.”

Banks are restructuring with urgency during a year in which costs grew rapidly. Toronto-Dominion Bank is reducing the number of employees by three per cent, amounting to more than 3,000 positions. Royal Bank of Canada has installed new management at City National Bank, its struggling California-based unit. Bank of Nova Scotia, the most international of Canadian lenders with large operations in Mexico, Chile and Peru, is set to unveil a new strategy during an investor day on Dec. 13 under new chief executive Scott Thomson.

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Canadian bank costs

“If you look historically, when the valuations get down at these levels, it’s normally a pretty good starting point” to buy Canadian bank shares, Leith said.

Residential mortgages are the largest part of the Canadian banking business and a major source of worry for economists. Households have loans with rates that rise and fall with the Bank of Canada’s overnight rate, or fixed-rate mortgages that reset periodically — usually every one to five years.

Over the next two years, about 2.2 million mortgages will be facing “interest rate shock,” according to a report last month from Canada Mortgage & Housing Corp. Someone with a $500,000 mortgage renewing a five-year mortgage taken during the lows of the pandemic might see an increase of almost $1,000 a month in their payments, the housing agency said.

Banks are trying to soften the blow — with a push from the federal government — by allowing some mortgage holders to spread out payments and extend the length of time it will take to pay off the loan. But that creates its own problems.

Rates have gone up so quickly that for some households, their fixed contracted payments aren’t sufficient to cover the interest on the loan, never mind paying down any principal. Toronto-Dominion had $37.4 billion of mortgages in that category at the end of October, 14 per cent of its Canadian mortgage portfolio.

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The banks are trying to whittle away at mortgage risk, with some success. For Royal Bank, loans with amortization periods of more than 35 years were 22 per cent of its Canadian mortgage portfolio as of the end of October, down from 25 per cent a year earlier. Toronto-Dominion also reduced the share of mortgages in that category.

Heavily indebted consumers and exposure to commercial real estate remain two of the bigger concerns facing Canadian banks, according to Peter Routledge, head of the country’s banking regulator, the Office of the Superintendent of Financial Institutions.

“But we haven’t seen very significant losses in either of those sectors,” and those two risks haven’t worsened in the six months, he said during a news conference on Dec. 8.

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“It seems like the Bank of Canada has done their job and nipped off inflation,” said Andrew Moor, chief executive officer of EQB Inc., the parent company of Equitable Bank, one of Canada’s top-performing financial stocks this year, up 42 per cent.

“We’ll see interest rates presumably start to decline next year, which will create a bit of relief on the mortgage side, and I think it’ll breathe a bit more life into the housing market.”

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