Canadian banks reported another solid quarter, despite fears of the Delta variant causing some concerns. While all banks beat consensus estimates, the magnitude of the beat is diminishing. Kim Parlee speaks with Mario Mendonca, Managing Partner, TD Securities about the outlook for Canadian banks.
Early this year, the banks beat estimates by, I think it was Q1 '21, beat estimates by 26%. So their actual results were 26% higher than what the average analyst was forecasting. That since declined to about 10% this quarter. And my sense is that it'll continue to decline, as you highlight. And the rationale for this is mostly that the analyst community is coming to terms with an understanding just how good this credit environment really is. The credit environment has been virtually perfect. The banks are releasing a lot of the reserves that they booked last year, releasing them back into earnings. And probably what's more important to me is that the impaired loan-loss ratio, this is loans that are actually going bad are so low. I'm not sure I've ever seen them this low. And ultimately, what I mean by the beats are diminishing is that as analysts, we now are coming to terms with that and we're building that into our estimates. So it's unlikely that the banks will beat our estimates as materially going forward. In fact, it might even go the other way in 2022 we could even see some earnings misses as the analysts adjust to this new environment.
You also talk about just how this quarter, in your opinion, marks the beginning of a shift in terms of the types of earnings we'll see. So, again, the analysts are catching up to your point in terms of what's going on the credit side, but you're seeing a shift of what's happening in terms of how the earnings are being generated.
Yeah, one of the most important things that characterizes this pandemic's, let's call it 2020 and most of 2021, or at least the first half, is that capital markets' revenues are very strong, trading underwriting revenue very strong. But the sharp decline in interest rates had constrained net interest margins. So net interest income, which is sort of the bread and butter of a retail bank, we weren't seeing growth in net interest income or strong margins because of the decline in rates. We also, because consumers were staying home, they weren't spending. We weren't seeing credit card spend. And as a result, we weren't seeing credit card revenues improve and other retail banking fees. What was interesting about Q3 '21 and it was something that could have been an enlargement or was foretold, that capital markets revenue would slow. We saw capital markets revenue decline 16% year over year, the first time in well over a year that we saw a decline in capital markets. But we also saw an increase in net interest income. It was only a modest 3%, but that means something to me. The trend of improving net interest income will likely continue. But what really stood out, what was awfully positive for some of these banks, was the sharp improvement in credit card revenue, not balances. People aren't adding to their balances yet, but they're clearly spending more. And we're seeing that translated into credit card fee revenue, interchange fees. Now, that could probably continue because at some point we're all going to start traveling again. And traveling is one of the big components of credit card spending. So I think that could drive revenues in 2022.
I guess the one kind of outstanding piece, of course, is Delta and what that all means and I mean, that's going to impact everything. I mean, how do you characterize that when you would you look at the potential of more mutations and these types of things? How do you how do you factor that into what you're expecting with bank earnings?
That's pretty tough to do. What I have done to try to build this in somewhat is I expect credit losses to increase somewhat in 2022. That's not a big stretch on my part. It almost has to because of how low they've been. But when I look at Delta, it makes me believe that the banks might be slightly more conservative in the release of their performing credit losses and we might see a slight increase in impaired loan losses, so the actual stuff that's gone bad. What I am not banking in, and I really hope I'm right about this, I'm not banking in another big lock down, a big shut down where credit card spending collapses, interest rates collapse again. I'm not building that into my estimates. I don't have the stomach for that. But I am trying to factor that into some extent in higher credit losses.
Let's talk about the individual banks and what you saw in terms of performance. And you talked about, I believe, that BMO and National were standouts in the quarter. Let's start with BMO. What did you see?
Well BMO for some time now has delivered the industry's best pre-tax pre-provision earnings growth. We referr to it as PTPP. It's essentially your earnings, ignoring the taxes and ignoring the credit losses. And BMO has delivered the best pre-tax pre-provision earnings now for some time. What made BMO stand out this quarter was they were the only bank that actually grew capital markets revenue in any meaningful way. It was up 10% year over year. My feeling here is that BMO is doing an excellent job on execution. But the bank may also be taking on a little bit more capital markets risk. We've seen them move up the high yield and leveraged finance league tables somewhat. I want to be clear. I don't think BMO is taking an undue risk here. But when you add a little bit of risk in capital markets, you're going to see your revenues grow. And I think that's what we saw for BMO. In National's case, something similar. They grew their capital markets revenue about 2%, which doesn't sound like much, except that many of the other banks were down about 20%. In Nationals' case, they didn't have a particularly strong Q3 2020. So the year over year comparison was a little bit easier, but Nationals' been very steady in capital markets as well.
How about CIBC? What did you see there?
CIBC has had a very strong, I think, a very strong year. Among the large cap, the big five, let's say, CIBC had the best year-to-date stock performance up about 34% year-to-date. And what's really driven CIBC is a resurgence in the domestic retail business. They had been laggards in domestic retail banking for several years. Now they've made some significant strides, not the least of which was to regain market share in mortgage lending. And I think that's an important part of the story because mortgages have been strong. Overall we're seeing CIBC reassert itself in domestic retail banking. They have been a strong bank in the past. They've lost their way and I think they're regaining and that's part of the reason why the stock has done well. One of the challenges CIBC could face in 2022 is that because it's had such a strong year, there is a period here where analysts, or rather investors, shift out of some of the better performing banks into the lesser performing banks. And the second thing that I think about CIBC is they've suggested on the street that they're going to continue to spend a little bit more aggressively. So their expense levels might be somewhat higher than what we saw in 2021, and that could strain performance. Still a very good bank. I just feel like CIBC's had their run. We might see that shift into other banks in 2022.
Let's talk about the rest then. I know you're restricted on TD. Royal, what did you see in this last quarter?
Royal, a perennial strong performing bank? It's got its structural advantages everywhere. Capital markets, wealth management, domestic retail, banking. And what I really liked about Royal's results is that they delivered good results without capital markets being the driver. What we saw there was a very strong retail bank. Margins are looking a little bit more stable, very good loan growth. Wealth management continues to truck along well. So when I look at Royal, really what I see is a bank that really should benefit from many of the themes we're referring to. Things like improving commercial loan growth, higher credit card spending, stronger net interest income. All of these factors really point to Royal. And although we haven't gotten to it yet and I imagine we will, the return of capital probably really applies to Royal as well in the form of dividends and buybacks. So I think Royal is hitting on a lot of the themes that I really like for 2022.
I will get to return of capital, I promise. I want to get to one more bank first, Bank of Nova Scotia. Obviously, they have operations much farther flung than others. So what do you see?
Early this year, I wrote a report and one of the big sections of the report was on Scotia, and I think I released a report in January, and part of the report said that we expected Latin America to be one of the important drivers in the second half of 2021. Our feeling was that Latin America, having been hit hard during 2020 would be one of those resurgent names in 2021. It did not play out. Latin America remains very much impacted by the pandemic. We're seeing it in particular in retail loan growth. Retail loan growth has been very weak in Latin America and retail loans are where Scotia generates the higher margins. So without the benefit of retail loan growth, not only are the base of loans not growing, but the margins you earn on those loans are lower. And I think that's really impacted Scotia. You know, I'm sort of crossing my fingers that the second half of 2022 might be the time when Scotian recovers, but ultimately Scotia doesn't screen well in a number of the areas that I'm focused on. So I'm going to have to see Latin America recover before I'm going to make another big bet on Scotia. It didn't play in 2021 the way I expected.
Yeah, well, a lot of it wasn't as of people expected, I know with 2021. Last question, or second last question I should say, is a return of capital. You talk about in your report the importance of dividends, share buybacks is going to be helping really drive share performance in the upcoming year.
Well, we know right now that our Canadian banks are not permitted to raise dividends or buy back stock. That is the status quo. But we all have to take a guess here on when that's going to change. Notwithstanding some of the risks associated with the Delta virus, my view is that before the end of the year, the banks will be given the go ahead to buy back stock and to raise dividends. That, if I've got the math right and the timing right, in and around the early part of December, when our banks are reporting the Q4 results, I expect them to announce dividend increases and buybacks. I think that's going to be one of the big stories for 2022, how these banks allocate capital. Will it be acquisitions, buybacks and dividend increases? I think all of the banks are positioned to raise their dividend, some more than others. On the dividend side, I'd say National and BMO are probably best positioned to raise their dividends. Royal and CIBC absolutely should raise their dividends as well, perhaps not as much as BMO and National. And then Scotia, I think you've got to be careful there. I don't think Scotia will raise their dividends as much as their peers, mostly because their earnings have been more impacted than their views. Then there's the issue of buybacks and return of capital through share repurchases. The banks with big capital ratios, +13%, approaching 14%, CET1 ratios, banks like Royal, BMO, really are in a very good position not only to raise dividends, but buyback a meaningful amount of stock. I think National and CIBC will lag somewhat in terms of their buybacks. They'll still buy back stock, but it'll be modest. And I think Scotia might be very modest in terms of buybacks. I don't believe that they are sitting on enough excess capital relative to their peers to really impress us with buybacks. It's more of a BMO and Royal story in that respect.
Last question for you, Mario. You talked about the fact that there's a return of capital and of course, with lots of capital, it means there might be some other options on the table as well. Are any banks talking about acquisitions seriously? Do you expect something good could happen?
Well, in the US space, there has been acquisitions. The regional banks have been active. Even credit unions have been active. Our Canadian banks so far, we haven't seen anything. I wouldn't rule that out. But there is an impediment to it. The main one is that valuations right now in the US are higher than Canada. And on those occasions when the bank, when the analysts or myself on my own, have asked the bank executives, what's your outlook on acquisitions? Very often they shrug their shoulders and say there's really not a lot out there at the valuations we like. So I think our banks are eager to do it. I think there are great regional banks in the US that could add to their portfolios. But at these valuation levels, I just don't feel like our banks are there. We did see a very small deal announced this morning. CIBC announced that they're buying the three billion dollar credit card portfolio from Costco. That's very, very modest. It's not going to attract a lot of capital for TD, or sorry for CIBC. But maybe that's what we should come to expect, more asset portfolio acquisitions and less in the way of big regional deals.
Mario, thanks very much.