What is the outlook for Canadian banks going forward?

Going into the reporting season bank analysts were telegraphing earnings growth of about 7.5% quarter over quarter, but relatively flat results year-over-year for most of the big six banks. Now that earnings have been released, it would appear that most banks exceeded Consensus forecasts with the exception of Bank of Nova Scotia where we would classify their results as more "in line” with expectations. Two things in particular stood out when looking at the results 1) credit quality remains stable or improved and 2) solid market performance was evident when we look from where the strength in earnings came.

First, let’s touch on credit quality where loan loss provisions declined for most of the banks when making year-over-year or quarter-over-quarter comparisons. The exceptions were Royal Bank where provisions crept higher marginally and Bank of Nova Scotia where the International division continues to put upward pressure on provisions. But overall it would appear as though credit quality continues to improve within the industry. We have written in the past that we aren’t that surprised by any improvement at this stage since interest rates remain so low and that credit quality likely won’t become an issue for banks and their earnings until borrowing costs begin to increase. Admittedly the debate on when such a move in rates will happen continues to get pushed off further into the future and likely means that credit quality for Canadian banks should remain stable for at least the next six to twelve months.

When we look back at the previous quarter we noted that banks were seeing lower earnings momentum for their retail banking segments. This was not a surprise to us considering the higher debt levels of Canadian households and an economic outlook that wasn’t particularly clear.We expected the lack of momentum to continue into the third quarter and while it’s fair to say that retail banking results were not firing on all cylinders, they were also reasonable considering the expectations of Bay Street for single digit growth. What made this past quarter a bit different from the first two quarters of the fiscal year was that the contributions to earnings growth from segments like wealth management and wholesale (capital markets) banking were much more visible. With capital market activity improving it really shouldn’t have been a surprise for analysts to see fee based revenue on asset growth or market sensitive revenue increase within these segments and for the most part the banks did not disappoint in this regard. Royal Bank in particular saw a material increase in their wholesale banking results which certainly helped that bank exceed Consensus forecasts on the earnings line.

Looking at capital management, capital levels in general remain stable, and we did see dividend increases out of Bank of Nova Scotia and Royal Bank. Scotia raised its quarterly dividend by 2 cents while Royal Bank bumped its quarterly dividend by 4 cents. Both banks should be in a position to bump those dividends again, albeit modestly, six months from now. One disappointment for us was that TD Bank could have easily increased its dividend but chose not to as that bank is about to change its CEO as Ed Clark is retiring after many years of service where he delivered a great deal of value for shareholders. TD actually had a strong quarter as most segments produced good results including both Canadian and U.S. retail operations and it remains the bank with the lowest payout ratio amongst the big six (therefore the bank with the greatest capacity to raise its dividend). However, management decided to put off any increase until the new CEO is in place.We don’t think shareholders were particularly well served by this decision, but it makes us all the more confident that we should likely see a dividend increase next quarter. The same can be said for National Bank and CIBC which should both be in a position to raise their dividends next quarter and while Bank of Montreal may do the same, such an increase may be modest unless earnings growth accelerates.

So overall, bank earnings season came and went without too many surprises as results managed to beat expectations mainly on the strength from wealth management and wholesale banking. It seems the market appears content with the results for now as most share prices either marginally increased or are holding reasonably well since the earnings reports were released. While we can be relatively happy with the results, we would also take this time to remind clients that there are future headwinds on their way for this sector, namely higher borrowing costs, but we admit such headwinds are likely not imminent. However, it still remains a challenging environment for retail banking. We also emphasize that market strength may not persist and support earnings as much as it did in the third quarter, so the ability for the banks to maintain or even increase earnings performance out of segments such as wealth management and wholesale banking will remain very dependent on how equity and fixed income markets perform going forward.

By The RM Group at Richardson GMP Limited. 

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