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Most of Canada’s big banks reported positive quarterly results, which helped to offset higher loan loss provisions. Monica Yeung, Vice President, Director and Portfolio Manager at TD Asset Management, discusses the outlook for Canada’s banking sector and the implications for investors.
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[AUDIO LOGO]
There was some divergence among the Canadian banks this latest earnings season. But one thing they pretty much all had in common was rising credit provisions. Joining us now with more on the quarter and where things may go from here is Monica Yeung, VP, Director and Portfolio Manager with TD Asset Management. Monica, great to have you back on the program again.
Great to be here again, Greg. Thanks for having me. So we've got another bank earnings season behind us right now. Give us your take overall on what we saw in the quarter.
Well, I'll just say off the top, it's been a challenging two years for the Canadian banks. We've had things like rising loan losses, NIM compression, also expense headwinds. And so in the context and the backdrop of that, I would say it was a pretty good quarter. We're starting to turn a corner. I don't think we're out of the woods yet, but we can see the light at the tunnel.
So the things I'm watching this quarter, number one-- most banks beat earnings. Five of six banks beat, on average by 4%. And they were what we would typically call high-quality beat, so things like better-than-expected wealth management results. We also got really good expense controls and then also a rebound in capital markets activity, and that was just the icing on the cake. So that's the first thing I'm watching.
Number two was also the first quarter of earnings growth in nearly two years. So we would have to go all the way back to Q2 of 2022 to see growth for the Canadian banks. This quarter, we saw them up about 2.5% on EPS. And so that's a really positive inflection or turning point, I think.
I think the most important thing, though, I take away from earnings, if you start to unpack some of the fundamentals, some really positive trends that I like to see-- so there's something that we follow called pretax preprovision earnings. It's a bit of a mouthful, but basically a proxy for earnings before credit losses, and that was actually up double digits.
So why is that? Loan growth was decent, up 4%. On top of that, we got stabilizing net interest margins, also a rebound in fee income, like wealth and capital markets. And then the kicker on top of all of that was really expense controls. So if you'll recall last year, the banks announced restructuring programs. We're now seeing the benefit of those now flow through into earnings.
So overall, I'd say a pretty decent quarter. Most banks beat earnings growth finally after two years, and then some good positive trends that we're seeing under the hood.
Some positive catalysts there. Let's talk about those provisions, though, because obviously, as we saw, the central banks, including ours, aggressively hike interest rates to try to tame inflation. We did hear about a strained consumer and strained Canadian households. Have we seen the worst of it now in terms of provisioning? We already have a Bank of Canada now that's starting to embark on what people are thinking is going to be the cutting cycle.
Absolutely. So that's kind of the elephant in the room, isn't it, the loan loss provisions. And really, the only sore point that I would point out this quarter, but also for the past few quarters now, ever since Bank of Canada has been hiking rates, we've seen loan loss provisions increase quite steadily. Just to give you some context, if you looked at this quarter's loan losses compared to a year ago, they're up over 50%.
So two key trends I'd point out. Number one, the areas where we're seeing loan losses, loan loss increasing is really in the Canadian consumer, so things like credit card, unsecured personal lines, a little bit in auto loans, and then pockets of US commercial. So, in particular, US commercial real estate-- we know that there's been some stress in US office, for example. So that's the first thing I'll call out.
The second thing is the composition of loan losses. So when we started this cycle two years ago, banks were putting on what we call stage one provisions. These are basically forward-looking estimates of losses because of a deteriorating macroeconomic environment. What we're seeing now is it's shifting into what we call stage two and three. So these are actually loans that have gone bad. They're impaired. They've gone nonpayment. Maybe they're in work out, and losses kind of going through that cycle of expectation into actualization.
So I think one interpretation of that is loan losses are accelerating. But I think for me, the way I would reframe it is really loans are kind of being realized. This is the cycle that we expect. You save for a rainy day, and the rainy day is here. And so all that tells me is that we're later in the cycle. To your question, have we peaked? I don't think we're quite there yet. We're peaking. I think we're getting closer to the end. What we've heard from bank management teams is it's likely an expectation of peaking back end of this year, early 2025. But we'll have to see. Rate cuts are definitely a positive.
All right, so interesting stuff there on provisions. You mentioned off the top that it was a pretty decent quarter. You saw a lot of things that looked positive for the banks. When we talk about the market reaction, on a daily basis-- I mean, one day is not everything-- but there was definitely some different reactions among the different-- I mean, what does that tell you overall about how the market reacted to this quarter?
So some pretty wide dispersion in price moves-- in fact, we'd have to go back all the way over a decade into the crisis to see moves in either direction of what we saw. And so what that really tells me is the fundamentals are quite different depending on which bank you look at. So to give you some examples, if you looked at loan growth this quarter, industry average was 4%
But on one side of the spectrum, you had National Bank up 8%. On the other side of the spectrum, you had Scotia Bank actually shrinking their loan book by 3%. Even credit loss provisions-- BMO had a big negative credit surprise. They saw more impaired loans in their US book of business. CIBC, on the other hand, is saying that they've seen the peak already. They expect total provisions to decline from here.
So all that really tells me, I think if I had to point to an analogy, there's that saying rising tides lift all boats. When the economy is good, all banks are growing, everyone's doing well. They're earning profits. They have operating leverage. In a case where the tide's coming out-- that's kind of the situation we're in now-- you really start to see some true colors, things like what banks are actually getting market share, which banks have provisioned enough, which ones actually have the expense controls that they say they do.
And so I would just say the takeaway for me is this isn't really an environment where you can close your eyes and buy all six banks in some equal weighted kind of fund. You really have to pick and choose your spots. You have to understand what's going on at an individual bank level.
A good reminder that people need to do their homework when they're thinking about these kinds of investments-- they have been lagging the market, the bank stocks, for about three years now. I mean, what's your outlook from here?
So in terms of valuation, banks are trading at a forward PE of 10 and 1/2 times. They have a dividend yield of about 5% And in the context of history, that's at the lower end of what we see banks trade at-- 10 to 12 times. But I do think that we need some clarity on a few things. Number one, we need to see loan losses peaking, some confidence, again, that we're on the other side of this credit cycle. Certainly, the Bank of Canada cutting rates-- that's a positive, and we'll follow closely as those successive rate cuts come in.
The other thing that I think would be really helpful for this group of stocks and could get it moving is a return to normalized earnings growth. So I like to think of banks as a levered play on the economy. So in the context of a fairly anemic growth rate in Canada this year, you can expect flattish earnings growth out of the Canadian banks for 2024. But if we see loan losses start to taper off, get that operating leverage and expense control come in, decent loan growth, we could see banks revert back to their 5% to 10% earnings growth trajectory, and that would be really positive for the group. [AUDIO LOGO]
[MUSIC PLAYING]
There was some divergence among the Canadian banks this latest earnings season. But one thing they pretty much all had in common was rising credit provisions. Joining us now with more on the quarter and where things may go from here is Monica Yeung, VP, Director and Portfolio Manager with TD Asset Management. Monica, great to have you back on the program again.
Great to be here again, Greg. Thanks for having me. So we've got another bank earnings season behind us right now. Give us your take overall on what we saw in the quarter.
Well, I'll just say off the top, it's been a challenging two years for the Canadian banks. We've had things like rising loan losses, NIM compression, also expense headwinds. And so in the context and the backdrop of that, I would say it was a pretty good quarter. We're starting to turn a corner. I don't think we're out of the woods yet, but we can see the light at the tunnel.
So the things I'm watching this quarter, number one-- most banks beat earnings. Five of six banks beat, on average by 4%. And they were what we would typically call high-quality beat, so things like better-than-expected wealth management results. We also got really good expense controls and then also a rebound in capital markets activity, and that was just the icing on the cake. So that's the first thing I'm watching.
Number two was also the first quarter of earnings growth in nearly two years. So we would have to go all the way back to Q2 of 2022 to see growth for the Canadian banks. This quarter, we saw them up about 2.5% on EPS. And so that's a really positive inflection or turning point, I think.
I think the most important thing, though, I take away from earnings, if you start to unpack some of the fundamentals, some really positive trends that I like to see-- so there's something that we follow called pretax preprovision earnings. It's a bit of a mouthful, but basically a proxy for earnings before credit losses, and that was actually up double digits.
So why is that? Loan growth was decent, up 4%. On top of that, we got stabilizing net interest margins, also a rebound in fee income, like wealth and capital markets. And then the kicker on top of all of that was really expense controls. So if you'll recall last year, the banks announced restructuring programs. We're now seeing the benefit of those now flow through into earnings.
So overall, I'd say a pretty decent quarter. Most banks beat earnings growth finally after two years, and then some good positive trends that we're seeing under the hood.
Some positive catalysts there. Let's talk about those provisions, though, because obviously, as we saw, the central banks, including ours, aggressively hike interest rates to try to tame inflation. We did hear about a strained consumer and strained Canadian households. Have we seen the worst of it now in terms of provisioning? We already have a Bank of Canada now that's starting to embark on what people are thinking is going to be the cutting cycle.
Absolutely. So that's kind of the elephant in the room, isn't it, the loan loss provisions. And really, the only sore point that I would point out this quarter, but also for the past few quarters now, ever since Bank of Canada has been hiking rates, we've seen loan loss provisions increase quite steadily. Just to give you some context, if you looked at this quarter's loan losses compared to a year ago, they're up over 50%.
So two key trends I'd point out. Number one, the areas where we're seeing loan losses, loan loss increasing is really in the Canadian consumer, so things like credit card, unsecured personal lines, a little bit in auto loans, and then pockets of US commercial. So, in particular, US commercial real estate-- we know that there's been some stress in US office, for example. So that's the first thing I'll call out.
The second thing is the composition of loan losses. So when we started this cycle two years ago, banks were putting on what we call stage one provisions. These are basically forward-looking estimates of losses because of a deteriorating macroeconomic environment. What we're seeing now is it's shifting into what we call stage two and three. So these are actually loans that have gone bad. They're impaired. They've gone nonpayment. Maybe they're in work out, and losses kind of going through that cycle of expectation into actualization.
So I think one interpretation of that is loan losses are accelerating. But I think for me, the way I would reframe it is really loans are kind of being realized. This is the cycle that we expect. You save for a rainy day, and the rainy day is here. And so all that tells me is that we're later in the cycle. To your question, have we peaked? I don't think we're quite there yet. We're peaking. I think we're getting closer to the end. What we've heard from bank management teams is it's likely an expectation of peaking back end of this year, early 2025. But we'll have to see. Rate cuts are definitely a positive.
All right, so interesting stuff there on provisions. You mentioned off the top that it was a pretty decent quarter. You saw a lot of things that looked positive for the banks. When we talk about the market reaction, on a daily basis-- I mean, one day is not everything-- but there was definitely some different reactions among the different-- I mean, what does that tell you overall about how the market reacted to this quarter?
So some pretty wide dispersion in price moves-- in fact, we'd have to go back all the way over a decade into the crisis to see moves in either direction of what we saw. And so what that really tells me is the fundamentals are quite different depending on which bank you look at. So to give you some examples, if you looked at loan growth this quarter, industry average was 4%
But on one side of the spectrum, you had National Bank up 8%. On the other side of the spectrum, you had Scotia Bank actually shrinking their loan book by 3%. Even credit loss provisions-- BMO had a big negative credit surprise. They saw more impaired loans in their US book of business. CIBC, on the other hand, is saying that they've seen the peak already. They expect total provisions to decline from here.
So all that really tells me, I think if I had to point to an analogy, there's that saying rising tides lift all boats. When the economy is good, all banks are growing, everyone's doing well. They're earning profits. They have operating leverage. In a case where the tide's coming out-- that's kind of the situation we're in now-- you really start to see some true colors, things like what banks are actually getting market share, which banks have provisioned enough, which ones actually have the expense controls that they say they do.
And so I would just say the takeaway for me is this isn't really an environment where you can close your eyes and buy all six banks in some equal weighted kind of fund. You really have to pick and choose your spots. You have to understand what's going on at an individual bank level.
A good reminder that people need to do their homework when they're thinking about these kinds of investments-- they have been lagging the market, the bank stocks, for about three years now. I mean, what's your outlook from here?
So in terms of valuation, banks are trading at a forward PE of 10 and 1/2 times. They have a dividend yield of about 5% And in the context of history, that's at the lower end of what we see banks trade at-- 10 to 12 times. But I do think that we need some clarity on a few things. Number one, we need to see loan losses peaking, some confidence, again, that we're on the other side of this credit cycle. Certainly, the Bank of Canada cutting rates-- that's a positive, and we'll follow closely as those successive rate cuts come in.
The other thing that I think would be really helpful for this group of stocks and could get it moving is a return to normalized earnings growth. So I like to think of banks as a levered play on the economy. So in the context of a fairly anemic growth rate in Canada this year, you can expect flattish earnings growth out of the Canadian banks for 2024. But if we see loan losses start to taper off, get that operating leverage and expense control come in, decent loan growth, we could see banks revert back to their 5% to 10% earnings growth trajectory, and that would be really positive for the group. [AUDIO LOGO]
[MUSIC PLAYING]
