Canadian bank shares have moved up significantly but is it justified or do they have more room to grow? Mario Mendonca, Research Analyst, TD Securities, talks to Kim Parlee about how Canadian banks performed in Q1.
Sure. The market's been up-- or the banks, rather, have been up-- in the last six months. It's hard to say. But the number is probably in the 20%, 25% range. Canadian bank valuations, though, were coming from a low. You may recall there was a lot of concern about our Canadian banks only, let's say, in the first quarter of 2016, the concern about oil prices in particular, but also housing.
As the concerns faded and earnings accelerated, we get this upside in the bank stocks. And that's where we're at now. Really, I think the movement of the bank stocks is a reflection of the risk going down and the earnings being so strong.
We heard from the banks before-- they were guiding, I think, about 7% to 10% earnings growth in 2017. How are they doing compared to that guidance?
We're one quarter in. It's only been one quarter.
And we had 15% EPS growth this quarter from the banks.
And it's not like one bank was 50% and the rest were 2%. The lowest growth was 13%, so every bank delivered excellent earnings growth. And it came on the back of a few things. There were a few factors that drove it.
One in particular was credit losses. Credit losses were much lower this year than they were last year. And it's for a simple reason that credit losses are lower.
It relates to oil and gas. We had oil and gas losses in 2016. We're unlikely to have them in 2017. In fact, we're likely to get the recoveries in 2017. And to be clear, that was a one-quarter-- we saw it this quarter, but it'll happen again next quarter. Very likely credit losses will be lower.
The second thing that really drove earnings beyond our expectations was expenses. Expense levels were much lower than anticipated. And that comes directly from those restructuring charges.
Well, last time we spoke, I thought it was interesting because you characterized 2016 as saying most of the banks essentially took big restructuring initiatives, got the costs out in preparation for some of those negative things you were talking about, oil prices being low and rates. Well, that reversed, and they had a great 2016. Is that theme still playing out in 2017?
Yeah, but more so. Now you don't have the negative of oil, but you do have the benefits of all the expense savings. And that's why earnings growth can be so strong, because the negatives that the restructuring charges are supposed to compensate for aren't playing out. And that's why 15% earnings growth-- and again, we're not talking about small entities here. We're talking about enormous companies generating 15% EPS growth.
And what's important is that they're backing it up with dividend growth. This quarter we also saw some very good dividend growth. TD, for example, raised their dividend 9% year over year.
Hmm. Let's get into the specifics. I'm sure we'll hear the themes kind of play out with each bank, but let's start with Royal. You still have a buy on Royal right now. Tell me what you saw in the last quarter.
Pretty solid quarter. What was probably the most important for me in Royal was their capital markets business. And I think everybody would agree Royal is a big capital markets player. And at the very end of the call, there were a number of questions about the outlook for capital markets, particularly in the US. And the message was pretty strong. Royal feels very confident of their US operations, particularly in capital markets.
The other thing I'd highlight is that Royal's capital level is so strong. That gives Royal the capacity to do some small tuck-in deals if they want to.
BMO, still a hold.
Yeah. BMO had a pretty solid quarter. The issue I've always had with BMO, it doesn't really relate to their operations. BMO's operations are pretty solid.
The issue I have is that I'm not comfortable with where their valuation is. They're trading at the same multiple as our own bank, TD Bank. That's not warranted for me. So solid bank, their capital levels look great. In fact, they did a great job on capital this quarter. I just don't really want to pay for that valuation.
Now let's talk about TD. You mentioned the dividend hike and the earnings growth as well.
That was important to me. The dividend hike of 9%-- I was calling for a 9% dividend growth. The bank beat the expectations for dividends by $0.02. That was a big point for me, because it's really important. If TD is going to talk about big earnings growth the way they have, it's important that they put their money where their mouth is and we get it on the dividend, and we did.
And where we're seeing probably the best momentum for TD is in their US business. We could see margins improve significantly if rates do move higher in the US. And overall, we want to see slightly better operating leverage from TD. We want to see that the expenses continue to trend down while revenue improves.
- Bank of Nova Scotia downgraded to a buy from an action buy.
Yeah. I did that mostly because of what I was seeing in the international business. Last quarter, Scotia's commercial growth in their international business was not strong. And we were-- I really was of the impression that would improve in the near term. It didn't.
And after two consecutive quarters of weak commercial loan growth, in moving from an action list to a buy, I want to take my foot off the pedal just a little bit. And frankly, I'm being a bit cautious. If in fact US interest rates do move higher and pull capital out of the international markets, that could have a more negative impact on Scotia than its peers.
And finally, where are you with CIBC?
CIBC hold. And the reason for that, it has nothing to do with valuation. It has everything to do with the challenge they're facing right now in the US specifically. They've made this bid for PVTB. They offered $47 for PVTB. This is a private bank corp in the US.
PVTB share prices are at a $57. CIBC either has to bid a very big price, around $60, $62 to get this deal done, or they lose their deal in the US. If they don't make the acquisition in the US, then they're trapped in Canada. And they're a very big mortgage provider in Canada.
Hmm. And so still concerns on the mortgage market.
I think so.
Yeah. You know, I think a lot of people have been talking about and seen the huge run-up in banks, US banks, because of what's been happening or at least proposed to be happening from President Trump, whether it's deregulation, cuts in corporate tax rates. How does that play out for Canadian banks? I mean, what do you see in terms of who benefits the most and what's happened with valuations?
I would really take the whole Trump phenomenon in three ways. One is interest rates. Interest rates are moving higher in the US. We know that the Fed governor is probably going to-- very likely going to raise rates in March and probably May.
That increase in rates has a significant impact on the margins for banks like TD in particular, but perhaps BMO as well, to a lesser extent Royal. So the move in interest rates to me is almost a given. And that will be definitely beneficial. In fact, the report that I published this morning, I specifically take up margin estimates for both TD and BMO on the back of that.
The others are a little harder to wrap your mind around. The first is taxes. Can we really count on US corporate tax rates dropping here in the near term? It is really difficult to pass tax legislation.
Even with Congress all on--
Yeah. But when a president starts to approach a 35% approval rating, it is hard to get Congress on board. So there's a couple of things that are concerning me there. And also, passing tax legislation when you have a debt level of-- what is it, $16 trillion, I don't think it's easy to get done.
As for regulation, that has maybe a little more support in it. But that too will take a lot of cooperation from Congress. So I'm not as enthusiastic about those two factors.
And I should probably highlight something very clearly. In all of my estimates for '17 and '18, at no point do I take into account the benefits of lower taxes or lower regulations. I've not included that at all in my estimates. That would just be a positive if it happens.
It would be. Well, let me ask you then, I guess, what the flip side of this is. What are the risks, I think, for Canadian banks moving forward, because I would think even the fact that you're-- I think from a market risk standpoint, not just for banks, the fact that these proposed tax changes don't go through it, that's a risk, I think, for the broader markets. But what do you see for Canadian banks?
Yeah. There is the common theme of housing. This comes up all the time. And I think any paper you read, you'll see that the average price of a home in Toronto was up 30% year over year. That continues to be an issue.
But I would put a slightly different spin on this. Very often people bring up housing in the context of losses, credit losses. That's not where the credit-- that's not the risk. The risk is not that our banks lose money on the housing loans.
The risk is that a material slowdown in the housing market slows everything down. So you'll see credit card growth slow, probably even some losses there, auto, all kinds of personal loans. It will slow down the economy. So it's not that the banks will experience big credit losses themselves. It's just that the loan growth and the growth overall will slow so significantly.
So that's the primary risk going forward?
That's the one I focus on.
Mario, thanks very much.