Canada’s big banks posted results that missed analyst expectations as they grapple with loan risks and a slowing economy. Kim Parlee speaks with Mario Mendonca, Managing Director at TD Cowen, about the latest earnings and the outlook for lenders going forward.
* Mario, before I get started, I just want to mention for people, for full disclosure on companies that are covered by TD Securities, you have to see the link to TD Securities' website at the end of this interview or the video. So just letting people know.
* I want to start with your take on the overall quarter, with all the banks. And the title of your report is "Estimates Grinding Lower, Easier to Deliver Positive Surprises." It sounds like this is a bad news, maybe it could be a good news story.
* Yeah, back in December 2022, I downgraded the group from overweight to market weight. And at that time, I talked about a few criteria. One was just valuation. I wanted to see valuation a little lower, something closer to 9 times forward earnings made sense to me. I wanted to see the beginning of the credit cycle. I want to see investors understand that the credit cycle has begun so they can put it behind them.
* And the third criteria was simply that I needed estimates to move a little lower. And that's exactly what's happened. Over 2023, the 2024 estimate is down 9%. And that's a meaningful number for our Canadian banks, particularly at a period when credit losses aren't driving lower estimates. That's just a natural 9% decline in forward estimates.
* And that means something to me. Because stocks, bank stocks, stocks generally don't do well when they're missing estimates. And just so we're clear, the banks missed estimates in Q3 '23. Royal beat numbers but that was largely because of a low tax rate. So the group as a whole missed estimates in Q3 '23, and that's just not good for stocks.
* So when I say estimates are grinding lower, that means something from a positive perspective. It's going to be easier for these bank stocks to meet and beat numbers in Q4, probably not Q4, because Q4 is when they're going to book, I think, some restructuring charges. But maybe Q1, Q2, we'll start to meet and beat numbers again. And that's positive for the group.
* We'll get into that outlook shortly with everybody. But let me just talk about each individual bank. And we'll start with BMO. You talk about in your note that there's a slowdown in capital markets activity, higher expenses. Of course, when there's less money coming in, those expenses look bigger. And that seems to be a theme for all the banks, not just BMO.
* Sure. Bank of Montreal took a fairly meaningful severance charge in Q3. There's probably another smaller one coming in Q4. BMO's expenses have been elevated throughout much of 2023. And capital markets have been weaker in 2023 than they were in prior years. But this actually sets up BMO really well for 2024.
* I think when you look at 2024, look at the benefits of the Bank of the West transaction, the benefits of flooding 2023 with expenses, including these severance charges, and what seems to be some green shoots in capital markets, BMO is one of the few banks that I look out into 2023 and see a more positive setup.
* So I have a buy rating on BMO largely because I feel that they're well positioned for 2024, both in terms of the recovery in capital markets and the bank's ability to generate positive operating leverage in 2024 because of all the expenses that went through in '23.
* Interesting. Let's talk about Bank of Nova Scotia. The one thing that stood out for me when I was reading your comments on this is still there's still very little clarity on their strategic direction. Do you have clarity on when you're going to be getting clarity?
* Yeah. Scotia, to me, is one of the most challenging banks out there. I think so much has to change at this bank in the next little while. They are de-emphasizing mortgages to close the funding gap. The funding gap is the gap between loans and deposits. They have far more loans than deposits in Canada.
* But I want to be very fair to the bank here, that funding gap has started to decline meaningfully. Now it's declining because they're growing their deposit base, but it's also declining because they're shrinking their loan growth. In fact, I think mortgages were down sequentially for Scotia.
* When you are not growing your loan book and your balance sheet isn't growing, it's very hard to grow pre-tax pre-provision profits. Scotia also, I think, is going to take a strategic hard look at their Latin American operations. The bank is in Mexico, Colombia, Chile, and Peru. Mexico is the only one I think that is untouchable. I think the bank is very pleased with their operations there.
The others, Colombia, Peru, and Chile, probably in that order, might actually be sold. I think the CEO, Scott Thompson, said that nothing's really off the table. I think the bank wants to clean up those operations first before they sell them. But you can't rule that out, the sale of those operations.
* As for when we're going to get clarity, my best guess is they'll hold an investor day in October this year where they lay out the strategic refresh. The market, and I can certainly speak for myself, it's very hard to be bullish on Scotia when I don't have clarity on what the strategic refresh is going to be.
* It's interesting. I mean, they've been in the South American and Latin American markets for decades. So that would be that would be a big move.
* CIBC, you talk about how higher provision for credit losses, much higher than expected, resulted in a significant EPS miss.
* Yeah. In CIBC's case, what made them distinct from all the other banks this quarter was just how high their credit losses were. And there were two areas that I think are worth highlighting.
* One is in Canada. They booked what we called higher performing loan reserves. Now these are reserves on loans that haven't gone bad. This is just their outlook, and they're saying that the macro picture looks weaker so they're booking higher performing loan reserves. And we did see some deterioration on the consumer side, slightly higher delinquencies and impairments.
* I want to be very fair to CIBC, I don't think CIBC's loan adjudication processes and policies are any different from the other banks. I don't think CIBC will stand out relative to the peer group in terms of Canadian consumer or small business credit performance.
* Where CIBC will stand out, I think, is in their US commercial real estate exposure. They had elevated losses in US commercial real estate this quarter. They're guiding to elevated losses over the next few quarters. I think the bank's lending approach in US commercial real estate is what's causing a little more stress for CIBC than their peers.
* In reports I wrote in 2021 and I think early '22, I demonstrated that CIBC's commercial real estate loan growth in the US was far higher than their peers. And generally, commercial growth in the US was much higher than their peers. I think, and I highlighted back then, that this could come back to hurt the bank. I think we're going to see over the next few quarters that CIBC's US office exposure, commercial real estate lending exposure leads to higher losses for CIBC than their peers. So in that respect, the bank could stand out to the negative.
* National, I've referred to National as the most binary call in the group. And what I mean by this is the bank's performed extremely well over the last few years, outperformed their peers. And up until recently, the bank was performing was trading not all that far away from Royal Bank, what we consider to be the premium valuation bank in the group.
* I thought that was unusual and unwarranted because of the mix of business of the bank. Very heavy in capital markets, which I don't put the same valuation on as I would a domestic retail bank. And what I've argued is a business that was growing far too quickly in Cambodia. The bank's loan growth in Cambodia was something in the neighborhood of 35% to 40%. I made the argument that you don't want to pay a premium valuation for that mix of business.
* This quarter, Q3, it kind of showed up. We're seeing margins come under pressure in Cambodia as deposit competition kicks in. But more importantly, we saw a big increase in gross impaired loans in Cambodia. And the bank was very clear on their call in saying that a global economic slowdown could affect tourism and trade, and that would have a more meaningful impact on their Cambodian business.
* We should note, though, 98% of the loans in Cambodia are secured. So I don't think they're going to necessarily have significant loan losses in Cambodia, but sentiment on the stock could turn fairly negative if we get a meaningful slowdown in loan growth and higher gross impaired loans.
* So I call national binary because so much of it really depends on what the global economy does to tourism and trade and the knock-on effects that has to Cambodia.
* Interesting. Royal, you've touched on a couple times, and you mentioned also that they had a one-time, I'll say, favorable tax rate, which helped their earnings in the quarter.
* Yeah. Now they wouldn't call it one-time. They would say it was business mix that resulted in the tax rating being low. And I get that. A lot of the earnings came from capital markets, which generally has a lower tax rate. But notwithstanding, the reason their numbers came in higher than I was expecting is because of that lower tax rate.
* But Royal, the Royal message is similar to BMO's in a way. Just as BMO has the Bank of the West deal closing, Royal is not far from closing the HSBC transaction. I think Royal will take some level of restructuring charge, or maybe they will call it just severance in Q4 '23. They've been flooding 2023 with expenses. All of this tells me that Royal's set up for a reasonably good 2024 in terms of expenses and the benefit of the synergies on the HSBC transaction.
* And then finally, like BMO, Royal is a very big capital markets player in the US. And listening to institutions like Morgan Stanley and Goldman Sachs and others, they're talking about these green shoots emerging in US capital markets. That could serve Royal and BMO really well in 2024.
* So interesting. Let me ask you, just final question, your outlook for the fourth quarter. The green shoots, you mentioned the capital markets. We can see that as maybe a nice tailwind. But restructuring costs and PCLs still weighing in terms of the credit cycle, I assume.
* Yeah. I think the Q4s are always really tricky, because you just don't know how much banks want to dump into Q4 to set them up for a good 2024. I'm really looking at 2024 now and saying, could these banks start to meet and beat numbers? And if they do, that will reflect positively on the stocks.
* Then the question's going to-- the big question for 2024 is going to be, when does the credit cycle really start? Does the credit cycle start early in '24? Does it start in the middle of 2024? Or does it not happen at all? Do we have such a soft landing that it barely shows up?
* The way I'm forecasting numbers is we get a very modest increase in credit losses, peaking around the middle of 2024. The big question is if I'm wrong on that and credit does become a big part of the storyline, with more than just normal credit losses, all these estimates are going to prove too high. We're all going to be lowering numbers and the stocks are going to suffer a little in 2024.
* My outlook is that things start to stabilize and the banks start to meet numbers again early in 2024.
* Great conversation, Mario. Thanks so much.
* Thank you.