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Canada’s largest banks reported solid earnings in the second quarter, but potential market headwinds remain. Mario Mendonca, Managing Director at TD Cowen, breaks down the key results and gives his outlook for the sector.
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Canada's big banks have reported their results, with most putting in a pretty solid quarter. Joining us for a breakdown is Mario Mendonca, managing director at TD Cowen. And we should say that for full disclosure of all the companies covered by TD Cowen, a division of TD Securities, please see the link at the end of the video.
Mario, it's good to see you. I want to start off by quoting you in your own report. You say at the beginning that this is the first quarter of positive operating leverage in two years, and that's notable.
Yeah. So for several years now, our banks have underperformed. They've underperformed the US regional banks, certainly the large banks. They've underperformed the life insurance companies. They have underperformed the TSX, the S&P 500, underperformed everything.
And it makes sense because their underlying fundamentals have been weak. Pre-tax, pre-provision profit growth has been soft. Operating leverage, which is the difference between your year-over-year growth in revenue and your year-over-year growth in expenses, has been negative. And that's not a good recipe for performance.
And prior to the quarter, I argued this would be our first quarter of positive operating leverage, and it was. It was modest-- 1.4%-- but it's still positive. And it's emerging that way because both sides of the equation are getting better. Both the revenue and the expense story are getting better.
On the revenue side, capital market-related revenues, accelerating. Net interest margins are not declining the way they have in the past. And on the expense side, the benefit of the restructuring initiatives are following through. Inflation is moderating somewhat as well, and that's allowing expense growth to moderate. So that's where the positive operating leverage came from.
You talk about, in your note, as well, that if you look at the history of the trading range for most of the banks, it's 10 to 12 times. And this is price to book, I think? Or price to equity-- you let me know.
Price to earnings.
Price to earnings.
Price to earnings.
Thank You. So where are we in terms of valuation, attractiveness, given where we're trading right now?
So you're right. 10 to 12 times earnings-- that is the normal trading range for our banks over the last many years. About 70% of the time, our banks trade between 10 and 12. Right now, they're a little over 10. Let's call it 10.5 times, 10.4 times, 2025. That is a lower end of the range, but it's still within the range.
The challenge our banks have, and one of the reasons why it's hard for me to have a blanket buy rating across the whole group, is that it's difficult to buy the banks when you're trading in that range and credit losses are migrating higher and estimates are migrating lower. That is not a good combination. Higher credit losses, lower estimates, and a multiple still north of 10 times isn't the place where I buy bank stocks, or at least I don't buy them en masse.
Get me to a place where credit losses have stopped rising, estimates are stable to rising, and multiples are sub-10 times. That would be a lot more interesting for me.
Yeah, I want to-- again, we'll get to the names, but one thing stood out for me. You talked about just the deteriorating environment, perhaps-- my words, not yours-- in terms of when you're looking at this. And you say that domestic consumer credit conditions are quickly deteriorating. Just tell me a bit more about that and what you see.
Yeah, I want to be very specific on this one because when people think about consumer credit, they often think mortgages. And although mortgages are the biggest part of consumer credit in Canada, that's not what I'm referring to when I say, deteriorating credit conditions.
While delinquency rates and impairment rates on mortgages are rising, they remain very low. And provided loan-to-value ratios remain in the 50% to 55% range, it's still very unlikely to me that we're going to see significant losses in the mortgage books. In fact, all this worry about mortgage resets is true. It's an entirely reasonable thing to talk about. But the issue is not what happens with mortgage losses, but rather, what mortgages do to other parts of the, let's call it, loan portfolios.
So beyond mortgages, the areas that you've got to be careful with are unsecured lending, or let's call it personal loans and credit cards. In the personal loan category, we're talking about auto loans, installment loans, lines of credit, and then, of course, credit cards. When you add those together, you get about 13% of the Canadian balance sheet.
When I say credit conditions are deteriorating, that's what I mean. I'm saying that category of loan-- impairments, delinquencies, and PCLs, or credit losses-- are rising. The big question for all of us is, how high will they go, and when will they stabilize? Because if you can get a good answer on those two, you can then start to make a much better call on when to buy bank stocks.
All right. Well, let's talk about the individual stocks because, as you mentioned, you saw a lot of diversion, I'd say, in some of the performance and how they actually got to it. So let's start with BMO, which had a big drop when the earnings came out-- in my mind, one of the biggest ones I've seen in a very long time. And you've got to buy on them right now, so tell me why and what you see.
So Bank of Montreal was, I think, everybody's darling going into 2024. The company had been very optimistic about their 2023 results. It did not work out that way. This quarter, the problem was credit losses in their US corporate commercial loan book.
There were three big items in particular-- one in insurance, one in commercial real estate, another in, I think, consumer products. Those are where the losses emerged from. BMO is big in commercial lending in the US. That's where the problems emerged for them.
The question now is, will BMO have another quarter like this? The bank is being very conservative, I think, in going forward because they can't stomach another quarter like Q2, or even Q1. They can't stomach another quarter where their guidance proves to be very wrong.
So just paying attention to human nature, my gut feeling is this bank is going to be very conservative with us on guidance. It's going to make it easier for the bank to meet and beat numbers. Now that the stock's corrected a fair bit, I think analyst estimates are about right. They're low enough for this bank to meet and beat. I think BMO is going to have a good Q2 and a better 2024, but anything could be better than what they delivered in Q2, for sure.
All right. Well, let's talk about Bank of Nova Scotia. You've got a hold on this one.
Scotia's a challenge bank for me. It's among the lowest rated in the group. And the reason for this is the bank-- I don't see where the growth comes from. Every metric I look at depicts a bank that's shrinking, shrinking in mortgages, shrinking in corporate lending in Latin America. They are a shrinking bank.
And I get it. I know why they're doing this. They're focused on bank primacy. It's going to take time to get there. They didn't raise their dividend this quarter, although they were expected to. That's a sign for me. It's a sign that the bank doesn't expect themselves to grow in the near term.
So I want to steer clear of Scotia. With that hold rating, I want to steer clear of them until I see at least some growth in that business. And it matters to me that they didn't raise the dividend. I don't want to overstate it, but it really does matter to me. They didn't raise the dividend we were expecting them to. It tells me growth is very challenged for Scotia.
All right. CIBC you've upgraded to a buy.
That was four months ago. I'm pleased that it happened four months ago and not recently because their recent performance has been very good. The stock did extremely well when they reported results. CIBC's got a great combination of two things. You've got a very low valuation. It's among the lowest value in the group, down there with Scotia. It is a very low-valued bank. But at the same time, the underlying performance is one you'd expect from a high-valued bank. Pre-tax, pre-provision profits growing. Credit conditions look stable. The capital ratio is over 13% They're guiding to better or lower losses in their commercial real estate segment in the US. So there's not a lot to not like about this bank. Good valuation with good underlying performance. Yeah, CIBC's rated very high in my books.
All right. And National-- hold on this one?
Yeah, National's been one of those very good performers over the last few years, one of the best performing stocks-- I think probably the best performing bank stock since 2017. My hesitation with National Bank is what it has been now for at least two years. I don't like the business mix.
I don't want over-exposure to Cambodia. They're growing their Cambodian loans at 25%, 30% a year. Gross impaired loans in Cambodia have moved materially higher. The credit losses haven't because they have good security in Cambodia and commercial real estate. I don't like that bet. I don't want to bet on the strength of Cambodian commercial real estate or real estate, generally.
They're also a very large capital markets bank, a business that can be rather volatile. When you trade at the premium that National does, with that business mix, I don't like that trade-off. But I have to acknowledge-- stock's done extremely well, and so have earnings, for some time now.
Last one we'll talk about, Mario-- Royal, and you've got a buy on Royal Bank.
Yeah, Royal has been a great call. Royal's been a good stock. They had a really good quarter. They're benefiting from very strong US capital markets conditions. They've announced the normal-course issuer bid, 30 million shares, which surprised a lot of people. They're buying back stock with a 12.8% capital ratio. And on the call, they said they're content with 12.5%.
The acquisition of HSBC went very well. They had what we call a close and convert. They closed and converted pretty much at the same time, allowing the synergies to emerge quickly. Royal, again, is that premium name in the banking sector, performing extremely well on an underlying basis. Now, the market is paying for it. It does trade at a big premium to the group. It makes sense given their underlying strength.
And we don't talk about TD, for obvious reasons, obviously. But let me ask you-- just last question, Mario. I mean, you talked about, at the very beginning-- or we talked about, at the very beginning, that part of the reason we had a nice quarter for most of the banks was this positive operating leverage, the quality, resurgent capital markets, the health of the wealth-management business. Do you expect those positive forces to continue for many of these banks going forward?
Yeah, I feel like pre-tax, pre-provision profit growth is going to remain reasonably strong, and I also think it will be supported by better margin performance. I really do. I think that a slightly steeper yield curve-- as the short end comes down, the long end remains somewhat elevated-- will support margins. I feel like deposit competition is easing somewhat, which is also supportive of margins. All of this tells me that we should have a pretty strong environment for pre-tax, pre-provision profit growth and operating leverage.
The big question is, what happens to credit? We need lower interest rates in this country to stave off some higher credit losses, particularly in that personal loan, unsecured loan category.
Mario, always a pleasure. Thanks so much for joining us.
Thank you. [AUDIO LOGO]
[MUSIC PLAYING]
Canada's big banks have reported their results, with most putting in a pretty solid quarter. Joining us for a breakdown is Mario Mendonca, managing director at TD Cowen. And we should say that for full disclosure of all the companies covered by TD Cowen, a division of TD Securities, please see the link at the end of the video.
Mario, it's good to see you. I want to start off by quoting you in your own report. You say at the beginning that this is the first quarter of positive operating leverage in two years, and that's notable.
Yeah. So for several years now, our banks have underperformed. They've underperformed the US regional banks, certainly the large banks. They've underperformed the life insurance companies. They have underperformed the TSX, the S&P 500, underperformed everything.
And it makes sense because their underlying fundamentals have been weak. Pre-tax, pre-provision profit growth has been soft. Operating leverage, which is the difference between your year-over-year growth in revenue and your year-over-year growth in expenses, has been negative. And that's not a good recipe for performance.
And prior to the quarter, I argued this would be our first quarter of positive operating leverage, and it was. It was modest-- 1.4%-- but it's still positive. And it's emerging that way because both sides of the equation are getting better. Both the revenue and the expense story are getting better.
On the revenue side, capital market-related revenues, accelerating. Net interest margins are not declining the way they have in the past. And on the expense side, the benefit of the restructuring initiatives are following through. Inflation is moderating somewhat as well, and that's allowing expense growth to moderate. So that's where the positive operating leverage came from.
You talk about, in your note, as well, that if you look at the history of the trading range for most of the banks, it's 10 to 12 times. And this is price to book, I think? Or price to equity-- you let me know.
Price to earnings.
Price to earnings.
Price to earnings.
Thank You. So where are we in terms of valuation, attractiveness, given where we're trading right now?
So you're right. 10 to 12 times earnings-- that is the normal trading range for our banks over the last many years. About 70% of the time, our banks trade between 10 and 12. Right now, they're a little over 10. Let's call it 10.5 times, 10.4 times, 2025. That is a lower end of the range, but it's still within the range.
The challenge our banks have, and one of the reasons why it's hard for me to have a blanket buy rating across the whole group, is that it's difficult to buy the banks when you're trading in that range and credit losses are migrating higher and estimates are migrating lower. That is not a good combination. Higher credit losses, lower estimates, and a multiple still north of 10 times isn't the place where I buy bank stocks, or at least I don't buy them en masse.
Get me to a place where credit losses have stopped rising, estimates are stable to rising, and multiples are sub-10 times. That would be a lot more interesting for me.
Yeah, I want to-- again, we'll get to the names, but one thing stood out for me. You talked about just the deteriorating environment, perhaps-- my words, not yours-- in terms of when you're looking at this. And you say that domestic consumer credit conditions are quickly deteriorating. Just tell me a bit more about that and what you see.
Yeah, I want to be very specific on this one because when people think about consumer credit, they often think mortgages. And although mortgages are the biggest part of consumer credit in Canada, that's not what I'm referring to when I say, deteriorating credit conditions.
While delinquency rates and impairment rates on mortgages are rising, they remain very low. And provided loan-to-value ratios remain in the 50% to 55% range, it's still very unlikely to me that we're going to see significant losses in the mortgage books. In fact, all this worry about mortgage resets is true. It's an entirely reasonable thing to talk about. But the issue is not what happens with mortgage losses, but rather, what mortgages do to other parts of the, let's call it, loan portfolios.
So beyond mortgages, the areas that you've got to be careful with are unsecured lending, or let's call it personal loans and credit cards. In the personal loan category, we're talking about auto loans, installment loans, lines of credit, and then, of course, credit cards. When you add those together, you get about 13% of the Canadian balance sheet.
When I say credit conditions are deteriorating, that's what I mean. I'm saying that category of loan-- impairments, delinquencies, and PCLs, or credit losses-- are rising. The big question for all of us is, how high will they go, and when will they stabilize? Because if you can get a good answer on those two, you can then start to make a much better call on when to buy bank stocks.
All right. Well, let's talk about the individual stocks because, as you mentioned, you saw a lot of diversion, I'd say, in some of the performance and how they actually got to it. So let's start with BMO, which had a big drop when the earnings came out-- in my mind, one of the biggest ones I've seen in a very long time. And you've got to buy on them right now, so tell me why and what you see.
So Bank of Montreal was, I think, everybody's darling going into 2024. The company had been very optimistic about their 2023 results. It did not work out that way. This quarter, the problem was credit losses in their US corporate commercial loan book.
There were three big items in particular-- one in insurance, one in commercial real estate, another in, I think, consumer products. Those are where the losses emerged from. BMO is big in commercial lending in the US. That's where the problems emerged for them.
The question now is, will BMO have another quarter like this? The bank is being very conservative, I think, in going forward because they can't stomach another quarter like Q2, or even Q1. They can't stomach another quarter where their guidance proves to be very wrong.
So just paying attention to human nature, my gut feeling is this bank is going to be very conservative with us on guidance. It's going to make it easier for the bank to meet and beat numbers. Now that the stock's corrected a fair bit, I think analyst estimates are about right. They're low enough for this bank to meet and beat. I think BMO is going to have a good Q2 and a better 2024, but anything could be better than what they delivered in Q2, for sure.
All right. Well, let's talk about Bank of Nova Scotia. You've got a hold on this one.
Scotia's a challenge bank for me. It's among the lowest rated in the group. And the reason for this is the bank-- I don't see where the growth comes from. Every metric I look at depicts a bank that's shrinking, shrinking in mortgages, shrinking in corporate lending in Latin America. They are a shrinking bank.
And I get it. I know why they're doing this. They're focused on bank primacy. It's going to take time to get there. They didn't raise their dividend this quarter, although they were expected to. That's a sign for me. It's a sign that the bank doesn't expect themselves to grow in the near term.
So I want to steer clear of Scotia. With that hold rating, I want to steer clear of them until I see at least some growth in that business. And it matters to me that they didn't raise the dividend. I don't want to overstate it, but it really does matter to me. They didn't raise the dividend we were expecting them to. It tells me growth is very challenged for Scotia.
All right. CIBC you've upgraded to a buy.
That was four months ago. I'm pleased that it happened four months ago and not recently because their recent performance has been very good. The stock did extremely well when they reported results. CIBC's got a great combination of two things. You've got a very low valuation. It's among the lowest value in the group, down there with Scotia. It is a very low-valued bank. But at the same time, the underlying performance is one you'd expect from a high-valued bank. Pre-tax, pre-provision profits growing. Credit conditions look stable. The capital ratio is over 13% They're guiding to better or lower losses in their commercial real estate segment in the US. So there's not a lot to not like about this bank. Good valuation with good underlying performance. Yeah, CIBC's rated very high in my books.
All right. And National-- hold on this one?
Yeah, National's been one of those very good performers over the last few years, one of the best performing stocks-- I think probably the best performing bank stock since 2017. My hesitation with National Bank is what it has been now for at least two years. I don't like the business mix.
I don't want over-exposure to Cambodia. They're growing their Cambodian loans at 25%, 30% a year. Gross impaired loans in Cambodia have moved materially higher. The credit losses haven't because they have good security in Cambodia and commercial real estate. I don't like that bet. I don't want to bet on the strength of Cambodian commercial real estate or real estate, generally.
They're also a very large capital markets bank, a business that can be rather volatile. When you trade at the premium that National does, with that business mix, I don't like that trade-off. But I have to acknowledge-- stock's done extremely well, and so have earnings, for some time now.
Last one we'll talk about, Mario-- Royal, and you've got a buy on Royal Bank.
Yeah, Royal has been a great call. Royal's been a good stock. They had a really good quarter. They're benefiting from very strong US capital markets conditions. They've announced the normal-course issuer bid, 30 million shares, which surprised a lot of people. They're buying back stock with a 12.8% capital ratio. And on the call, they said they're content with 12.5%.
The acquisition of HSBC went very well. They had what we call a close and convert. They closed and converted pretty much at the same time, allowing the synergies to emerge quickly. Royal, again, is that premium name in the banking sector, performing extremely well on an underlying basis. Now, the market is paying for it. It does trade at a big premium to the group. It makes sense given their underlying strength.
And we don't talk about TD, for obvious reasons, obviously. But let me ask you-- just last question, Mario. I mean, you talked about, at the very beginning-- or we talked about, at the very beginning, that part of the reason we had a nice quarter for most of the banks was this positive operating leverage, the quality, resurgent capital markets, the health of the wealth-management business. Do you expect those positive forces to continue for many of these banks going forward?
Yeah, I feel like pre-tax, pre-provision profit growth is going to remain reasonably strong, and I also think it will be supported by better margin performance. I really do. I think that a slightly steeper yield curve-- as the short end comes down, the long end remains somewhat elevated-- will support margins. I feel like deposit competition is easing somewhat, which is also supportive of margins. All of this tells me that we should have a pretty strong environment for pre-tax, pre-provision profit growth and operating leverage.
The big question is, what happens to credit? We need lower interest rates in this country to stave off some higher credit losses, particularly in that personal loan, unsecured loan category.
Mario, always a pleasure. Thanks so much for joining us.
Thank you. [AUDIO LOGO]
[MUSIC PLAYING]
