Earnings may have been higher for Canada’s big banks last quarter. But Mario Mendonca, Managing Director, TD Securities, tells Kim Parlee why he wouldn’t call this a particularly high-quality quarter, despite the lenders beating consensus estimates by an average of 7%.
Originally published June 9, 2022
KIM PARLEE: Five of the big six Canadian banks beat consensus estimates this quarter, with CIBC missing, but by less than 1%. Earlier I spoke with Mario Mendonca, from TD Securities, on how the big banks performed, and what may lie ahead.
Mario, let's start off with the overall take on the Canadian Bank earnings. You say in your note, and I quote, "We would not call this a particularly high-quality quarter." Tell me a bit about what you saw.
MARIO MENDONCA: Sure. So earnings were up. EPS was up about 5%, year over year. Pre-tax, pre-provision profits were up about 4%.
When I referred to not a particularly high-quality quarter, what I was referring to is the nature of the way the banks beat estimates. All six banks beat estimates, beat the Street estimates. CIBC was just marginally under Street estimates.
But when I looked at why they beat estimates, it was mostly from lower credit losses. Credit losses remained extremely low. And no bank, perhaps other than National, actually delivered revenue that was higher than what we were looking for.
I would call that a relatively weak-quality quarter, when the beat comes almost entirely from credit.
KIM PARLEE: Yeah. Well, let's dig in on that a bit, in terms of some other themes. Tell me a bit more about credit. What are you seeing right now?
MARIO MENDONCA: Yeah, credit's an interesting one. Because going into the quarter, for the last 3 months, our Canadian banks have performed poorly. Now, part of it was that their valuations were heavy relative to some of the US banks. But they clearly traded down.
The logic there was the market was becoming concerned that credit would start to pop up. The concern, of course, is that with the Fed raising rates, and Bank of Canada raising rates, and pulling liquidity out of the market, that it would result in a hard landing and credit losses would emerge.
We just didn't see that this quarter. There was no evidence of that. Delinquency rates remain very low. Gross impaired loan formations are low.
Unemployment remains very good. And just speaking to the bank executives, you certainly get the feeling that credit is not going to be the big story in the near term. It could very well.
We will likely have a credit cycle at some point. But sitting here today, I'm not going to build into my numbers and into my recommendations the notion of a big credit cycle.
KIM PARLEE: Interesting. We will watch that, though. As you mentioned, near term not an issue. But going forward, we'll have to see. What about margins?
MARIO MENDONCA: Yeah, margins are the really good-news part of the story for the Canadian banks. For some period now we've seen margins under pressure, as rates have declined. This move in rates, particularly the more recent move in rates, obviously that pushes the short end of the curve up. But we're also seeing the 5-year move higher.
As rates move higher, banks with very large deposit bases-- Royal fits in well, in that respect-- they have a very large deposit base. You'll see your margins expand a little faster than the banks that are more wholesale funded. I think this has a very important effect on all of our banks. But particularly for the very large deposit-rich banks.
KIM PARLEE: Let's run through some names and just get your take. BMO, you're saying that their pre-tax, pre-profit momentum is starting to slow?
MARIO MENDONCA: Yeah. They're tracking in line with the peer group, in terms of their pre-tax, pre-provision profit growth. That's good. It's just not exceeding the group the way it was in the past.
Part of the reason for this is they're a very capital-markets-heavy bank. They generate a lot of the revenue from capital markets, and that's slowing. They don't have as much momentum to rising rates as some of the other banks do.
That would make me believe that their pre-tax, pre-provision profit growth is slowing. What they really have in their favor is that in 2023 the benefits of the Bank of the West acquisition kick in. I think you'll see the most pre-tax, pre-provision profit momentum improve in '23. The second half, I think they might lag their peers a little.
KIM PARLEE: OK. Then for Bank of Nova Scotia. Same thing. You're saying their pre-tax, pre-provision profit is likely to lag its peers. But they did have a solid quarter?
MARIO MENDONCA: Well, we did. They did a solid Q2. The reason why I think Scotia could lag, I think, is they don't have nearly the upside to rising rates as their peers that we just talked about. But they're in a very interesting position. In their international business, they've now positioned the bank for falling rates. Now it's actually negative to the bank's net interest income when rates rise.
That's just the position the bank is taking. They've done a great job in the past of making these predictions. Right now they're positioned for falling rates.
I still have the view that rising rates are going to drive higher margins across the banking group. They're also low in my pecking order because I can't really see where the strong earnings momentum emerges in 2023.
While I pointed to BMO's Bank of the West acquisition, there really isn't something of a similar size and meaning in Scotia that will drive the momentum in 2023.
KIM PARLEE: What about CIBC? You make mention of capital levels of CIBC, in terms of their opportunities going ahead. But what else stood out?
MARIO MENDONCA: Well, a similar issue for CIBC. Their capital ratio is very strong on an absolute basis. On a relative basis similar to Scotia, they don't quite have the same capital flexibility as their peers.
What's interesting about CIBC is they've grown their loans at such a strong clip over the last 12 to 18 months. That's been good. It's been driving better earnings. But they clearly reached the point where that has to slow.
I think it'll slow for two reasons. One, they've absorbed a lot of their excess capital. And you can only grow so quickly.
The second is, they've pushed fairly meaningfully into commercial real estate lending in the US. That's an area they probably want to take a little of a breather here, if there is going to be a credit story in 2023. That's one of the areas I think you have to watch.
KIM PARLEE: What about National?
MARIO MENDONCA: National is sort of an enigma for me. I have always been so surprised by how this bank can grow their capital markets revenue in almost any environment. This quarter, for example, their trading revenue was up 39%, year over year.
Nothing like that among the other banks. They have this long-volatility position that benefits them when the world looks a little shakier. They have very strong equity derivatives trading.
That's what's driving this very strong capital markets result. There was a bit of a scare this quarter, in that we saw gross impaired loans increase in their Cambodian businesses, called ABA. I think the banks got that under control. I kind of understand why that would be the case.
I don't think those higher gross impaired loans in Cambodia are going to really impact earnings. But that was one of the areas you have to watch from National, going forward.
KIM PARLEE: Mario, we can't talk about TD, for obvious reasons. But tell me about Royal. You talked about the power of margins with deposit-rich banks. So what do you see?
MARIO MENDONCA: Well, certainly Royal benefits from higher margins. I think that's going to be an important part of the Q2, of the second half of 2022's story for Royal. But what's been confusing for me is a bank with all of these advantages, structural advantages, scale, hasn't really performed like a premium bank in the last few quarters.
In fact, Royal was the only bank that didn't grow revenue year over year, in Q2. They didn't grow their pre-tax, pre-provision profit year over year either. So the bank isn't exhibiting the characteristics you'd expect from a premium bank.
I am feeling much more optimistic about the second half. I think with the margin expansion story for Royal, plus what appears to be just some improving momentum in their loan growth, Royal is positioned for a pretty solid second half of the year. But I think you have to be very candid here. This premium bank, at least in the last few quarters, has not displayed premium performance.
KIM PARLEE: Let me ask you this final question. You mentioned what you're going to be watching with individually, with each of these banks as you move ahead. But as we move to whether it's a slowdown or a recession or a stagflation, how does that play out in these types of earnings, as you look ahead?
MARIO MENDONCA: Yeah. That's the really tricky one. For now, in the very near term, what I'm focused most on is how margins are going to drive the stories a little higher. I'm focused on capital markets potentially slowing.
But it seems inevitable that at some point, we'll be talking about a credit cycle. When that happens, the question, will it be a consumer-led recession? Will it be more corporate?
That'll affect which banks are hurt more. I think another question we're going to ask is, if it is commercial and business-lead, what sectors are going to be hurt? Is it going to be commercial real estate? In which case, I might be a little concerned about CIBC'S growth in their US commercial real estate portfolio.
Could it be agriculture? In which case, maybe we'd be looking a little more at BMO, which is big in ag. So the cycle is coming. There isn't evidence of it now.
I know from experience, it's not wise as an analyst, or even an investor, to start making a bunch of calls based on a credit cycle, where there's just no evidence to suggest it's here yet. So I'll get on that story at some point. When it happens, I'll have to be very, very clear on what sectors I think will be the most impacted. That, of course, will lead me down the path to which banks I think will be the most impacted.
KIM PARLEE: Mario, thanks so much for your time.
MARIO MENDONCA: Thank you.