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Canadian banks ended 2020 by beating street estimates handily in Q4. Kim Parlee speaks with Mario Mendonca, Managing Director, TD Securities, on whether this bodes well for 2021, and whether banks and insurers could benefit from an economic recovery as vaccines become available to the public.
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- Mario, I know that you've just put out a really great note talking about the banks and a higher-level note in terms of what to look for for the upcoming year. I want to start, though, if I could, with the fourth quarter. And you talk about how good earnings-- I thought we saw some peaks right across the board-- not having a lot of predictive value. So how come?
- Well, the banks all beat consensus numbers and my numbers, my estimates, by a very handy amount. I think in BMO's case it as much as 26%. And what we observed in the quarter was that credit losses were extremely low-- 27 basis points of impaired credit losses in the quarter. That compares to what would be more normal for the banks of about 40. What they really benefited from in the quarter was all the government assistance and the payment deferrals that the banks instituted. And so we fully expect credit losses to ramp up in 2021. And for that reason, I looked at the actual earnings in the quarter as not having a significant predictive value.
- Let's talk a bit about what maybe does have more predictive value. You talk about, quite emphatically, business mix throughout your note, the importance of where banks are generating their revenues and their profits and the differences between them. And maybe to start with, what we saw for the full year of 2020 was the banks that performed well had a business mix that was better for this environment, and those that didn't didn't. So maybe just talk about what you mean by business mix.
Yeah. In 2020, business mix mattered more than it has almost any other year I can reflect on. And there were several ways you would look at business mix. In one case, the banks that are very capital markets in orientation-- think National Bank, Royal Bank-- those banks, very much capital markets in orientation, they benefited because capital markets revenues were up 30% year over year-- particularly strong trading results. And the banks that were more retail in their orientation-- think Scotiabank, maybe CIBC, as well-- banks that had more exposure to net interest income didn't perform as well because interest rates were lower, and that caused net interest to be lower.
But also banks that have a real focus on customer activity. So think of things like credit card purchases, deposit fees, payment fees, insurance revenues. Banks with a very retail orientation suffered somewhat during the lockdown because customer activity slowed materially. So I really looked at business mix as a real differentiator in 2020.
- OK, so what does that say, then, for 2021? I mean, who is positioned well for what we hope will be happening, which is recovery?
- So if we start off with the premise that credit's not going to be the story in 2021, that credit losses will be higher, but the banks have already built significant reserves to cope with that. So if we lay that, and we stipulate that credit's not going to be the story, then revenue mix again becomes more of the story. And in this case, what I would point you to is it is very difficult for banks to have another capital markets year, 2021, like 2020.
In fact, in 2009, when capital markets were very strong, we had 2010 and 2011, two consecutive years of lower capital markets revenue. And that's what I'm looking for in 2021-- lower capital markets revenue. Now, two banks that really benefit from capital markets would be Royal and National. Royal generates 20% of their revenue from capital markets, National about 26%. And so as capital markets ease off, trading revenue slows, those two banks might be at a slightly unfavorable position. Again, banks with a more retail focus-- think Scotiabank, think CIBC-- those banks have much more of a retail focus, and their business model might be slightly more in favor.
- You talk about in your note, as well, that you have seen a shift in favor of the underperformers in 2020-- the BMOs, the Bank of Nova Scotias-- and picking up some steam right now from an equity price valuation standpoint for that reason, I assume.
- I think so. I mean, there's the basic argument that you buy the stocks that underperformed in one year, they're more likely to sort of narrow the valuation gap in the next year. And that's a fair trade that I've seen investors make over time. But I think there may be a little bit more going on, particularly in the case of Scotia that was really hurt by the lockdowns in their international segment. So the fundamentals are also playing a role.
- Let's maybe just dig into a little bit in Bank of Nova Scotia. Really just tell us a bit more about what was happening there.
Well, in our summer months, the lockdowns eased a little bit in North America largely because it was summer and the case count had started to decline. Of course, Latin America, it was their winter months, and their case counts were accelerating at a time when ours were declining. And the lockdowns in places like Peru, Chile, Colombia were far more strict than the lockdowns we had in North America. I've heard stories of the military policing the streets of Lima, Peru, ensuring that people aren't leaving their homes.
That sort of lockdown resulted in Scotiabank seeing a very substantial decline in their fee income and credit card fees, deposit fees, payment fees, insurance fees. It was a very significant effect for Scotia. What's sort of moving in Scotia's favor right now is as we move into our winter, Latin America is moving into their summer, so their lockdowns are ending as ours are sort of ramping up again. But what might really favor the international business as they come out of these lockdowns is their winter will commence in May, but by then, I would assume that Latin America would have had time to distribute the vaccine. So they may not have to go into a severe lockdown in their winter months, which would start in May 2021. So Scotia's international business, which was a big negative in 2020, could actually move in their favor in '21.
- You have Scotia as one of your top picks amongst the banks and the life insurance companies. You talk about BMO as another one. Tell me why.
- Well, BMO really makes sense to me in the context of their US operation. The US operations were really hurt by much lower margins. BMO managed through that well. But the US business, in particular, would suit BMO.
But beyond just their US business, what I've observed from the bank over the last couple of quarters is very strong what we refer to as pre-tax, pre-provision earnings. In Q4 2020, BMO grew their pre-tax, pre-provision earnings by 7%. It was second-best in the group.
And what it really speaks to is the momentum in the business model, and, importantly, good expense control. Because BMO's expense control would have been among the best in 2020. I think that sets them up nicely for 2021.
- You've got an overweight stance on the banks overall, but you don't really have a sector preference right now between the banks and the insurers. How come?
- Well, I really feel like if you buy into the notion that the yield curve will steepen, that will benefit net interest income, that's beneficial to the banks. But a steeper yield curve and higher long-term rates is also very relevant to the Canadian insurers. And companies like Manulife still trade at less than their book value. In a rising rate environment, a name like Manulife, Industrial Alliance, perhaps, should benefit, as well. So really, what I'm trying to reflect is that this move toward a higher 10-year not only applies to the Canadian banks, but is also relevant to the Canadian insurers.
- Let me ask you one thing that a lot of people watch right now-- the capital reserves of the banks right now. I know for some of the banks, the common equity tier 1 ratios have never been higher, but, of course, they can't do anything with it right now because of regulators. So how do you expect that to play out? Will they wait until regulators give them some options, or do you expect they maybe need to make some acquisitions along the way?
- Well, if you had told me that capital ratios went higher at the end of this year-- they would be higher than they were at the beginning of this year-- with everything going on with the pandemic, I would have been surprised, but that's what happened. Capital ratios increased to 12.3% from 11.7% at the very beginning of the year. That's a meaningful improvement in the capital ratio.
And if you indulge me for a moment and buy into the notion that the bogey, the appropriate minimum or practical minimum, let's call it, is 11%, the banks at 12.3% are currently sitting on $28 billion of excess capital. And if they don't buy back stock and they don't do acquisitions and they don't raise their dividend, by the end of this year, they could be sitting on $36 or $37 billion of excess capital. In the note, I referred to what would happen if the banks all raised their dividends by 15% today? All it would do is take that $37 billion at the end of the year that I forecast and make it $36 billion. A 15% increase in the dividend only takes a billion dollars out of the common equity-- an inconsequential amount in the context of that quantum.
So I feel like our banks should be raising the dividends right now. They're not permitted to. The regulator doesn't permit it right now. But a logical chain of events would be something like some point in the middle of the year, OSFI allows the banks to raise dividends, some point late in the year they allow them to buy back stock and be a little bit more aggressive on acquisitions. The challenge with making acquisitions right now is you don't know what you're buying, you don't know the sort of headaches that you're getting in an environment like this. But I think the banks will have capital flexibility from us, be late in the year.
- It's an interesting time. Mario, I want to finish with the question I always ask you-- what should I be asking you that I'm not asking you?
- That's interesting. So I started off with the premise that credit would not be the story in 2021. Where could I be wrong? If I'm wrong about credit, what will cause me to be wrong about credit? That's one thing that I actually ask myself a lot.
- And what could that be?
- Yeah. Ultimately, I really believe that the Canadian consumer, once the help they're getting, let's say, from the government-- the government relief-- is pulled away and the government support is pulled away, the Canadian consumer will be able to function well again. That unemployment will settle back in and they'll function normally.
The risk, of course, is that this vaccine isn't as effective as we hope, there's another lockdown, unemployment remains very high, and credit losses are even higher than what I expected. I'm not counting on that happening, but that's the one thing that I was thinking about a lot when I was writing that note. Could I be wrong on this credit story?
- Mario, always a pleasure. Thanks so much
- Thank you.
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- Well, the banks all beat consensus numbers and my numbers, my estimates, by a very handy amount. I think in BMO's case it as much as 26%. And what we observed in the quarter was that credit losses were extremely low-- 27 basis points of impaired credit losses in the quarter. That compares to what would be more normal for the banks of about 40. What they really benefited from in the quarter was all the government assistance and the payment deferrals that the banks instituted. And so we fully expect credit losses to ramp up in 2021. And for that reason, I looked at the actual earnings in the quarter as not having a significant predictive value.
- Let's talk a bit about what maybe does have more predictive value. You talk about, quite emphatically, business mix throughout your note, the importance of where banks are generating their revenues and their profits and the differences between them. And maybe to start with, what we saw for the full year of 2020 was the banks that performed well had a business mix that was better for this environment, and those that didn't didn't. So maybe just talk about what you mean by business mix.
Yeah. In 2020, business mix mattered more than it has almost any other year I can reflect on. And there were several ways you would look at business mix. In one case, the banks that are very capital markets in orientation-- think National Bank, Royal Bank-- those banks, very much capital markets in orientation, they benefited because capital markets revenues were up 30% year over year-- particularly strong trading results. And the banks that were more retail in their orientation-- think Scotiabank, maybe CIBC, as well-- banks that had more exposure to net interest income didn't perform as well because interest rates were lower, and that caused net interest to be lower.
But also banks that have a real focus on customer activity. So think of things like credit card purchases, deposit fees, payment fees, insurance revenues. Banks with a very retail orientation suffered somewhat during the lockdown because customer activity slowed materially. So I really looked at business mix as a real differentiator in 2020.
- OK, so what does that say, then, for 2021? I mean, who is positioned well for what we hope will be happening, which is recovery?
- So if we start off with the premise that credit's not going to be the story in 2021, that credit losses will be higher, but the banks have already built significant reserves to cope with that. So if we lay that, and we stipulate that credit's not going to be the story, then revenue mix again becomes more of the story. And in this case, what I would point you to is it is very difficult for banks to have another capital markets year, 2021, like 2020.
In fact, in 2009, when capital markets were very strong, we had 2010 and 2011, two consecutive years of lower capital markets revenue. And that's what I'm looking for in 2021-- lower capital markets revenue. Now, two banks that really benefit from capital markets would be Royal and National. Royal generates 20% of their revenue from capital markets, National about 26%. And so as capital markets ease off, trading revenue slows, those two banks might be at a slightly unfavorable position. Again, banks with a more retail focus-- think Scotiabank, think CIBC-- those banks have much more of a retail focus, and their business model might be slightly more in favor.
- You talk about in your note, as well, that you have seen a shift in favor of the underperformers in 2020-- the BMOs, the Bank of Nova Scotias-- and picking up some steam right now from an equity price valuation standpoint for that reason, I assume.
- I think so. I mean, there's the basic argument that you buy the stocks that underperformed in one year, they're more likely to sort of narrow the valuation gap in the next year. And that's a fair trade that I've seen investors make over time. But I think there may be a little bit more going on, particularly in the case of Scotia that was really hurt by the lockdowns in their international segment. So the fundamentals are also playing a role.
- Let's maybe just dig into a little bit in Bank of Nova Scotia. Really just tell us a bit more about what was happening there.
Well, in our summer months, the lockdowns eased a little bit in North America largely because it was summer and the case count had started to decline. Of course, Latin America, it was their winter months, and their case counts were accelerating at a time when ours were declining. And the lockdowns in places like Peru, Chile, Colombia were far more strict than the lockdowns we had in North America. I've heard stories of the military policing the streets of Lima, Peru, ensuring that people aren't leaving their homes.
That sort of lockdown resulted in Scotiabank seeing a very substantial decline in their fee income and credit card fees, deposit fees, payment fees, insurance fees. It was a very significant effect for Scotia. What's sort of moving in Scotia's favor right now is as we move into our winter, Latin America is moving into their summer, so their lockdowns are ending as ours are sort of ramping up again. But what might really favor the international business as they come out of these lockdowns is their winter will commence in May, but by then, I would assume that Latin America would have had time to distribute the vaccine. So they may not have to go into a severe lockdown in their winter months, which would start in May 2021. So Scotia's international business, which was a big negative in 2020, could actually move in their favor in '21.
- You have Scotia as one of your top picks amongst the banks and the life insurance companies. You talk about BMO as another one. Tell me why.
- Well, BMO really makes sense to me in the context of their US operation. The US operations were really hurt by much lower margins. BMO managed through that well. But the US business, in particular, would suit BMO.
But beyond just their US business, what I've observed from the bank over the last couple of quarters is very strong what we refer to as pre-tax, pre-provision earnings. In Q4 2020, BMO grew their pre-tax, pre-provision earnings by 7%. It was second-best in the group.
And what it really speaks to is the momentum in the business model, and, importantly, good expense control. Because BMO's expense control would have been among the best in 2020. I think that sets them up nicely for 2021.
- You've got an overweight stance on the banks overall, but you don't really have a sector preference right now between the banks and the insurers. How come?
- Well, I really feel like if you buy into the notion that the yield curve will steepen, that will benefit net interest income, that's beneficial to the banks. But a steeper yield curve and higher long-term rates is also very relevant to the Canadian insurers. And companies like Manulife still trade at less than their book value. In a rising rate environment, a name like Manulife, Industrial Alliance, perhaps, should benefit, as well. So really, what I'm trying to reflect is that this move toward a higher 10-year not only applies to the Canadian banks, but is also relevant to the Canadian insurers.
- Let me ask you one thing that a lot of people watch right now-- the capital reserves of the banks right now. I know for some of the banks, the common equity tier 1 ratios have never been higher, but, of course, they can't do anything with it right now because of regulators. So how do you expect that to play out? Will they wait until regulators give them some options, or do you expect they maybe need to make some acquisitions along the way?
- Well, if you had told me that capital ratios went higher at the end of this year-- they would be higher than they were at the beginning of this year-- with everything going on with the pandemic, I would have been surprised, but that's what happened. Capital ratios increased to 12.3% from 11.7% at the very beginning of the year. That's a meaningful improvement in the capital ratio.
And if you indulge me for a moment and buy into the notion that the bogey, the appropriate minimum or practical minimum, let's call it, is 11%, the banks at 12.3% are currently sitting on $28 billion of excess capital. And if they don't buy back stock and they don't do acquisitions and they don't raise their dividend, by the end of this year, they could be sitting on $36 or $37 billion of excess capital. In the note, I referred to what would happen if the banks all raised their dividends by 15% today? All it would do is take that $37 billion at the end of the year that I forecast and make it $36 billion. A 15% increase in the dividend only takes a billion dollars out of the common equity-- an inconsequential amount in the context of that quantum.
So I feel like our banks should be raising the dividends right now. They're not permitted to. The regulator doesn't permit it right now. But a logical chain of events would be something like some point in the middle of the year, OSFI allows the banks to raise dividends, some point late in the year they allow them to buy back stock and be a little bit more aggressive on acquisitions. The challenge with making acquisitions right now is you don't know what you're buying, you don't know the sort of headaches that you're getting in an environment like this. But I think the banks will have capital flexibility from us, be late in the year.
- It's an interesting time. Mario, I want to finish with the question I always ask you-- what should I be asking you that I'm not asking you?
- That's interesting. So I started off with the premise that credit would not be the story in 2021. Where could I be wrong? If I'm wrong about credit, what will cause me to be wrong about credit? That's one thing that I actually ask myself a lot.
- And what could that be?
- Yeah. Ultimately, I really believe that the Canadian consumer, once the help they're getting, let's say, from the government-- the government relief-- is pulled away and the government support is pulled away, the Canadian consumer will be able to function well again. That unemployment will settle back in and they'll function normally.
The risk, of course, is that this vaccine isn't as effective as we hope, there's another lockdown, unemployment remains very high, and credit losses are even higher than what I expected. I'm not counting on that happening, but that's the one thing that I was thinking about a lot when I was writing that note. Could I be wrong on this credit story?
- Mario, always a pleasure. Thanks so much
- Thank you.
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