The latest federal budget included a much anticipated tax hike for financial institutions, like banks and insurance companies. Anthony Okolie speaks with Mario Mendonca, Managing Director, TD Securities, about the implications for Canadian banks and his outlook for the sector.
- The latest federal budget included a much-anticipated tax hike for financial institutions like banks and insurance companies. It calls for a one-time 15% tax on taxable income over $1 billion and a 1.5% tax hike for profits over $100 million. For more, I'm joined by Mario Mendonca, Managing Director at TD Securities. Mario, how significant could this new tax be on bank earnings?
- Sure. One thing I want to address, though-- the 15% tax is applied only to 2021 earnings, so it's really a one-time tax windfall. It is not an ongoing thing. The 1.5% is an ongoing tax. The market generally doesn't put too much emphasis on one-time things. We really care about forward earnings.
But let me try to put this all into some perspective. In the budget, they estimate that the impact would be about $6.1 billion over five years. That is not a large number to our Canadian banks. I know $6.1 sounds like a big number, but to our Canadian banks, that isn't that large a number. In 2022, we estimate pre-tax income for our Canadian banks-- this is the big six banks-- to be about $81 billion. If I were to grow that 5% over the next four years, cumulatively over the five-year period, you'd be looking at $450 billion over five years.
Now, remember, that $6.1 billion is not just a bank issue, it also applies to the insurance companies. So if you take the six big insurance companies-- I'm including Intact and Definity in this-- that would be another $100 billion in pre-tax income over the next five years.
So when you pull it all together, you're looking at $6.1 billion on $550 billion-- about 1.1%. That is not a big number. And you can tell the market didn't really react to it in a big way, because, actually, all the bank stocks were up the day after the budget. So the market, I think, appropriately looked at the number and said, you know what? It's not as big as we thought it would be. It's not as material a number as we thought it would be.
The more important thing is what could this do to mortgage growth? And that's something I'd be happy to talk about as well.
- So let's talk about that. What is your outlook on mortgage growth?
- Yeah. There have been periods in the past when, for example, the foreign buyers tax or the tax implications to foreign buyers-- that is more relevant to mortgage growth for our Canadian banks. And that's what came out of the budget. There have been times in the past where we've seen stuff like this. The foreign buyer tax in BC in 2016, the foreign tax in the GTA in mid-2017, both of those had double-digit impacts on mortgage volumes-- declines, that is.
So we could see an impact on overall mortgage volumes. But the balance of mortgages, the banks will continue to grow their mortgage balances. But the new mortgages could come off in the sort of double-digit range.
I think what's actually more important than mortgages or, rather, these foreign buyer taxes, what are the effects of higher interest rates? And what could that do to mortgages? One thing I think you really should consider is that, with rates moving up as much as they have, call it 125, maybe as much as 250 basis points before all is said and done, there's precedent for that as well. In the '80s and '90s, when we saw mortgage rates move up that much, we saw, again, mortgage volumes come under pressure-- double-digit. And it makes sense that it would because when your borrowing costs increase by 125 basis points plus, the size of the house you can buy comes down a fair bit. We estimate about 12%.
So the implications of higher interest rates, I think, are even greater than the implications of the foreign buyer's tax. Remember, foreign buyers only account for about 8% of all ownership in Vancouver and about 5% of ownership in Toronto. So we're not looking at very big numbers here.
ANTHONY OKOLIE: So given that, do you expect Canadian banks to outperform this year?
- Well, it's a challenging period here, because in the very near-term, we fully expect higher interest rates to drive better margins for our Canadian banks. Clearly, that is a positive for earnings. We expect loan growth to be good here in the near-term as well.
But early on this year, around February 11-- that was the date of the report-- in that report, I wrote that the Canadian banks were looking a little bit heavy from a valuation perspective, that the market had mostly priced in the benefit of rising rates. What happened over the next few months is valuations came under pressure. The banks have gone from about, say, 11.4 times 2023 earnings back to about 10.2 times '23 earnings. So they've lost some of the momentum.
I call it a tricky time to call bank stocks because I have two things sort of pushing me in different directions. On the one hand, I really do believe that earnings are going to be strong over the next few quarters and valuation looks pretty good again. So I feel constructive on the banks. I feel like they're going to have a solid couple of quarters and the market will like these things again.
Here's the risk, though. The US investor has already moved beyond the rate benefits. The US investor is looking at US banks and is already taking these stocks down in anticipation of the fallout of a rate increasing cycle. They're already pricing in the credit implications, as in higher credit losses at some point because of higher rates.
And look at what that's done to the US banks. Over the last three months, the US money centers and regional banks are off 19%. In Canada, the banks are off 4%. So clearly in Canada, we are not making that call yet. The Canadian investor is still, for the most part, pricing in the benefits of higher rates and an improving loan growth picture, whereas the US investor is already moving on to the credit cycle.
So this is my best feeling. This is my best guess for what's going to play out over the next little while. The banks are going to look good. Earnings are going to look solid. Earnings growth will be good. Margins will benefit. But at some point, probably later this year, we're going to have to price in the credit implications as they're doing in the US. So positive now, I suspect I'll be less positive as the year progresses.
ANTHONY OKOLIE: Mario, great insights as usual. Thank you very much for joining us.
- Thank you.