Scotia Capital analyst Meny Grauman thinks recent economic data “highlights why further caution is warranted” for investors heading into the start of earnings season for Canadian banks later this week.
“In July, we co-authored a report with our quant team suggesting that Canadian banks were setting up well to play some catch-up not just versus U.S. peers, but also versus Canadian lifecos whose outperformance versus banks has looked increasingly stretched by historical standards,” he said. “In that report, we argued that this call was tactical in nature, and that we were still negative on banks longer term given ongoing risks of a hard landing if inflation did not slow enough to allow for rate cuts in 2024. In short, we saw a window of opportunity as investors got more confident in the outlook for rates and the economy.
“However, events over the last two weeks now suggest that this window of opportunity may have closed even before it really opened as stronger-than-expected economic data on both sides of the border (especially July’s CPI reading in Canada) has the market once again ratcheting up rate expectations. Not helping sentiment is Moody’s decision to downgrade 10 small and medium-size U.S. banks, and Fitch warning that it may do the same.”
In a research report released Monday titled Good News Is Bad News (and Bad News Is Probably Bad Too), Mr. Grauman predicted third-quarter results will not show signs of a recession, but he thinks “they are also unlikely to paint a particularly compelling picture either as bank earnings continue to be weighed down by slowing loan growth, sluggish fee income, flat-to-down margins, negative operating leverage, and normalizing PCLs with the potential for some lumpiness from U.S. office exposure.”
“Add to this rising capital levels (we assume another 50 bps increase to the DSB buffer in December), and the outlook for the banks remains very challenging barring a dream scenario of a soft economic landing, coupled with moderating inflation (back towards 2 per cent), and materially lower rate,” he added.
Mr. Grauman is now forecasting core cash EPS of $2.17 for the sector in Q3, up 2 per cent versus the prior quarter, which he attributes to a higher day count, but down 4 per cent year-over-year.
“As the banks get set to report Q3 results it is becoming abundantly clear that both the Canadian and U.S. economies are holding up better than expected,” he said. “While that seems like good news, the problem is that it is not good news for either inflation or more importantly rates. This inflation/rate dynamic remains the key risk to the outlook for banks in our view and is a key reason we remain quite cautious on prospects for the group as we look out to F2024. Our annual numbers continue to assume that PCL ratios continue to head higher, while loan growth continues to slow. At the same time we expect margins to be flat to down through our forecast horizon, and for operating leverage to be negative into next year when it begins to improve thanks in part to potential restructuring charges. Meanwhile, our outlook on fee income is conservative and certainly leaves room for improvement in wealth and capital markets-related revenue streams.
“Put it all together and our EPS estimates for F2023 declined by 3 per cent to $8.83. Meanwhile, our F2024 EPS estimates also fell 4 per cent $9.22. We continue to forecast regular dividend increases in line with medium-term EPS growth expectations, but are not modeling any share buybacks except for TD, which is sitting on an unusually large amount of excess capital in the wake of the cancellation of the FHN deal. Both our F2023 and F2024 EPS estimate are on average in-line with consensus.”
Mr. Grauman lowered his target prices for four banks:
* Canadian Imperial Bank of Commerce ( “sector perform”) to $62 from $66. The average on the Street is $62.79, according to Refinitiv data.
* National Bank of Canada ( “sector outperform”) to $107 from $109. Average: $105.09.
* Royal Bank of Canada ( “sector outperform”) to $141 from $143. Average: $136.52.
* Toronto-Dominion Bank ( “sector outperform”) to $101 from $103. Average: $93.23.
He maintained his targets for these banks:
* Bank of Montreal ( “sector outperform”) at $143. Average: $132.02.
* Canadian Western Bank ( “sector perform”) at $27. Average: $29.15.
* EQB Inc. ( “sector outperform”) to $100. Average: $95.63.
* Laurentian Bank of Canada ( “sector perform”) at $38. Average: $44.31.
“It is probably not surprising that we take a conservative approach to numbers heading into another reporting season, and as a result come in below the Street for pretty much every name we cover,” he said. “We are not predicting anything dramatic this earnings season, but just a combination slower revenue growth and higher loan loss provisions.
“Although we are not above the Street for any of our names, we have a relatively more favourable view of CM and BMO given the underperformance of the shares heading into earnings, while NA looks relatively more vulnerable, as does CWB among the smaller banks. Bigger picture we highlight that results will likely take a back seat to macro data and rate moves for the foreseeable future.”