All but one of the Canadian big banks beat street estimates in Q1. Kim Parlee speaks with Mario Mendonca, Managing Director, TD Cowen, about the outlook for the Canadian financial sector as the economy slows, and any potential impact from the Silicon Valley Bank collapse.
* I think every bank in the US is coping with some level of deposit runoff. It makes sense. During the pandemic, deposits surged in the US through quantitative easing. We're seeing the flip side now. Quantitative tightening is having an effect on deposits. You're seeing a runoff.
*Now, some banks have deposit franchises that may be not as sticky, not as reliable, and that's one of the cases with, I'm sorry, SVB. That issue of deposit runoff led them to sell significant securities, realize the loss. They're raising equity, or trying to raise equity, and I don't really see that as an issue in Canada for our Canadian banks.
*There's no doubt, though, that deposit runoff is happening in the US. We're seeing some shift to higher cost deposits in Canada, all of which would speak to a period where margins stop expanding. We've had a tremendous period of margin expansion. That probably slows.
* And I think it's also safe to say that balance sheet growth has to slow. But that makes a lot of sense because during the pandemic, balance sheets really exploded, much to the-- they increased significantly. And now we're seeing the offset, the decline. But I wouldn't point to the issues that SVB and perhaps some other regional banks as being indicative of what we would face in Canada, no.
* All right. Well, let's talk about what we saw in Canada. So the first-quarter results came out, earnings. All the banks basically beating estimates, with the exception of Scotia. The title of your note is called "Nearing the end of net interest margin expansion." And credit gradually normalizing. Mortgages, nothing to see here yet.
* One, you're a good headline writer, so thank you for doing that. But secondly, just tell us just the overall story to give us a little more behind that.
* Yeah. So margins continue to expand this quarter, but we got very clear indications from the bank executives that we are closer to the end than we are at the beginning. And it makes sense. It's for the reasons that I just touched on a moment ago, that we are clearly seeing deposit runoff in the US. The cost of deposits is rising as deposit betas rise.
* We're seeing a shift to higher cost deposits, all of which speak to an environment where margins are pretty much done expanding. It might get a little bit more. But we've seen a lot of margin expansion, so it makes sense that we're going to see margins stabilize, maybe even come down over time. That's part of the story.
* The other one, clearly, I talked about is that credit losses are normalizing. We're not seeing a deterioration, though. We are seeing higher credit losses emerge in consumer loans. Think personal loans, like lines to credit auto. That's happening in both Canada and the US.
* But I want to be very straight on this-- we're not seeing a material increase in credit losses. Impaired loan loss provisions are still running at about 20 basis points, which is well below what I would consider normal, at about 36 basis points. And as for mortgages, we can get into more detail. At this point, we're not seeing any deterioration in the mortgage portfolios.
* It's interesting. I think part of it is you're right. It's not near where, I'll say, normal is. But at the same time, we've been abnormal for so long, that it feels even the reversion back to normal feels uncomfortable. Let's go through each bank.
* Start with BMO. You talked about a slowdown in capital markets activity but on a valuation basis, still looking OK. So just what do you see with BMO?
* Yeah, Bank of Montreal's results were good. They beat numbers. But there are clearly some concerns here that capital markets are slowing down. They had very strong capital markets results in '21 and '22, and this is the flip side of it. I'm confident that by the second half of this year, the capital markets numbers will look a little bit better, just simply on a year-over-year basis.
* There's a reason why I remain somewhat bullish on BMO, is the Bank of the West transaction. I look at that deal-- it's going to drive balance sheet and earnings growth at a period when loan growth and balance sheet growth are hard to come by. What I do think we have to acknowledge is that there's a lot of deposits in the US franchise for BMO.
* There's a $145 billion today. You add Bank of the West to that, which closed on February 1, gets you well over $200 billion in deposits. We could see some deposit runoff at BMO in their US business, but that might force them to have to raise their funding costs, compete more aggressively for deposits. So I think the margin story for BMO, which has been a really good story, is probably over, just as it is for a lot of banks.
* Mario, you've got a hold rating on Bank of Nova Scotia, of course, and they're one of the ones that did not beat estimates. And you've got some concerns. You talk about margins capital and lack of clarity on strategic direction.
* Yeah, Scotia's a really tricky one. About a year ago, maybe a little more than a year ago, I downgraded Scotia. And the argument I made then is that their margins would look weak while their peers would be strong. And that's played out. We've now seen their margins underperform now for some time.
* Although, I think, on a relative basis, their margin performance might start to look a little bit better as margins stop being a big part of the driver, it stops being as big a distinguishing feature that Scotia's margins aren't strong and their peers are. But the challenge I have is that Scotia has to go through a meaningful strategic review. The new CEO Scott Thomson's been clear that the old way of doing business at Scotia, they need to revisit that.
* So what I think we could see from Scotia in the next little while is quite weak balance sheet growth in a period when peers with deals, like, say, Royal or BMO, are benefiting from their acquisitions. We could see Scotia's balance sheet growth look quite weak as they cycle out of, say, mortgages or personal auto, which is probably where they're a bit overweight. That won't look good on Scotia, in my view.
* A period where their balance sheet could be flatlining or shrinking while their peers are growing will reflect poorly on them, so that conservative posture I have taken on Scotia feels appropriate still.
* What about CIBC? You make a really interesting note here that the growth that they had in 2021, '22 could be a vulnerability in 2023?
* Yeah. Back in 2021 and '22-- early in '22, I was highlighting that CIBC's growth in commercial lending, particularly US commercial real estate lending, was off the charts. It was better than everybody's by a mile. And it made sense. The bank had a lot of excess capital. They wanted to put it to work, and they did.
* The problem now is commercial real estate, particularly US commercial real estate, looks like it's going to soften, especially exposure to the office space. Looking at CIBC's exposure in the US, there's about 18.5 billion US of US commercial real estate. 20% of that is to the office space, where I'd say their vulnerability is greatest. And of that 18.5 billion, 40% of that amount would be below investment grade.
* So I don't really view this as a big credit concern for CIBC at the time or at this moment, but, for sure-- or my strong view is that their loan growth there in the US could really, really soften as they get a little bit further back in that business.
* Let's get to the last two-- National and Royal. What did you see with National?
* National continues to surprise. They delivered solid margin performance out of their domestic retail business, which was surprising to all of us because they have far more loans than deposits in their domestic business, so you wouldn't have expected them to have good margins, but they did. On the flip side, they have a very strong deposit franchise in their wealth management business, which is driving strong margins.
* But, really, what sets National apart is the businesses that no one else has. They have this very large business in Cambodia, where loans are growing 35% a year and credit losses are extremely low. And Credigy, which is a distressed-- not so much distressed assets. It used to be more on distressed assets.
* It's a whole-sub business where they buy these portfolios and work them out. And National's done extremely good job of growing those two businesses. What really stood out for me at National this quarter, besides just that very strong margin performance you saw in domestic retail, is that their credit losses were only four basis points. And that probably is unsustainable, and they're the first to tell you that that would be unsustainable.
* So a strong result out of National. I'd be a little bit more cautious going into Q2, largely because that unusually strong margin performance they put up in the quarter doesn't seem like it's sustainable in Q2. So I'm still cautious on National and, frankly, cautious on the group as a whole.
* And for Royal, you make the note that it has, from a stock perspective, outperformed the group. It trades at a premium. I guess it just always comes down to, is the premium warranted?
* Yeah. And I wouldn't call this necessarily a strong quarter for Royal. They beat the number, but they beat it more on things that the market may be not as keen to pay for, things like really high trading revenue and lower credit losses. The margin story wasn't as good as we hoped.
* My sense from Royal is that margins would stop being a big contributor to their differentiated performance, but I thought that was going to happen a little later on in the year. We saw it clearly in this first quarter, the management's guiding for a challenging quarter in Q2 from margins and then things improving in the second half. I'm not sure I totally would agree with that take. I think margins have stopped expanding, period, and we're not going to see, necessarily, a recovery in the second half.
* But Royal is a very strong player. We expect them to benefit from the acquisition of HSBC. We expect them to continue to grow their asset book or their loan book, whereas others might have to constrain growth. So while the valuation is pretty rich, this is not a bank I like to bet against.
* The one thing you do want to get from Royal, though, to really solidify a positive outlook is they've got to get their hands around expenses. Expense growth was very high this quarter, the highest in the group in a number of expense categories. I would expect better from Royal on the expense side.
* Hmm. And I should mention, of course, we don't talk about TD, for obvious reasons. Let me just ask you the last question. I mean, a lot of people looking to the banks and wondering how they're going to weather the downturn-- I mean, recession, no recession, whatever it looks like, how it plays out. But how do you see the banks a year from now, two years from now when you think ahead in terms of things they have to manage?
* Well, I clearly took a more conservative posture on the group. I downgraded them March 20 to market weight. And for some people, that might not seem like much. But it means a lot to me because my predisposition with the banks is almost always positive. So I think the banks are going to go through a period here where the balance sheets stop growing or they grow, but they grow at a very low pace, relative to what we see in the past, that constrains pretax preprovision profit growth.
* So now let's fast forward a year from now. Let's assume that the economy has slowed, we're going through, maybe, a mild recession, mortgage rates are elevated and people are having difficulty paying their mortgages. I don't believe that mortgages will necessarily result in higher credit losses for our banks. But to the extent that you have to pay a lot for your mortgage, that's money you can spend on a vacation, on dinners out, money that you would generally put into the economy.
* So if interest rates remain this high, we're clearly-- I think we're going to go through a period of weak economic growth, which will lead to credit losses, but perhaps not in the mortgages themselves. It'll be areas like credit cards or personal loans because of a slowing economy. But I think our bank governor knows this. I think we know that this economy won't function particularly well if mortgage rates remain this high a year or two years from now.
* So my suspicion is, eventually, we're going to see interest rates come down in Canada to cushion the blow for these mortgage borrowers.
* Mario, always a pleasure. Thanks so much.
* Thank you.