Banks head into Q4 with investors looking for better days ahead

A street light on Bay Street in Canada's financial district is shown in Toronto on Wednesday, March 18, 2020. THE CANADIAN PRESS/Nathan Denette

The majority of Canada's big banks are heading into fourth-quarter earnings this week riding high as fears around mortgage defaults and a recession ease.

But analysts say the banks will have to show there’s enough earnings growth ahead to justify current valuations that are on the high end of historic trends.

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“We believe that the banks now must prove out the thesis,” said Canaccord Genuity analyst Matthew Lee in a note.

The S&P TSX bank index is up around 12 per cent since last quarter’s results, including a 19 per cent gain for Scotiabank and 17 per cent climb for CIBC.

The exception is TD, which was hit with a US$3 billion fine and growth limits in the U.S. because of its anti-money laundering deficiencies. Its stock is down slightly this quarter amid these struggles.

Lee said, overall, the banks are now trading at a “lofty” 12.1 times earnings, a level justified by a constructive growth environment, robust capital positions and loan books that look reasonably healthy, but they will need to show improved margins ahead to maintain their stock prices.

“With sector valuations full, we believe the next leg of upside will have to come from earnings growth,” Lee said.

Investors that have propped up bank stocks are already looking past the still-worsening credit fundamentals and sluggish loan growth to the turnaround ahead, said Scotiabank analyst Meny Grauman.

“Canadian bank stocks have seen some good momentum since the summer, as the soft landing scenario for both the U.S. and Canadian economies took hold,” he said.

“The current rally is less about what the banks report in Q4, and more about their outlooks for next year and beyond.”

Even TD appears promising when looking further out, said Grauman.

“We also continue to like the risk-reward profile for TD, even though this is very much not a consensus view."

While U.S. regulators have limited TD's asset growth, Lee said he thinks TD won’t drastically underperform its peers over the medium term, with levers like mortgage growth and its U.S. wholesale business to help drive gains.

The bank has been going through a leadership shakeup as it works to fix the gaps found by regulators and there's more change ahead after chief executive Bharat Masrani announced he's stepping down next year.

With so much change going on at the bank, and its limited guidance so far for fiscal 2025, analysts will be most closely watching its outlook, said Lee.

TD aside, the perception of Canadian banks has shifted notably from recent quarters where bank stocks were under pressure over concerns that defaults would spike as borrowers buckled under the strain of high interest rates.

Lenders started building up provisions for loan losses as central banks raised interest rates. A key fear was that as a wave of homeowners renewed their mortgage at higher rates, they wouldn't be able to make up the difference in their new monthly payments.

The Bank of Canada had warned in May that mortgage renewals were one of the main risks to the country’s financial system, especially if there were a recession.

So far though, the job market has seen only a gradual softening, rather than a big shock, helping ease fears in the financial sector.

Borrowers have also been helped by looser-than-expected financial conditions, said TD Economics in a report last week.

“Mortgage holders have moved away from the cliff edge,” said economist Maria Solovieva in the report.

Declining interest rates, as the Bank of Canada has reduced its key rate by 1.25 percentage points since June to 3.75 per cent, have also been important.

The combination of lower rates, as well as fierce competition between lenders on mortgages, mean aggregate mortgage payments should go down by 1.2 per cent next year, whereas before, they were expected to grow 0.5 per cent, she said.

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Borrowers have also been acting prudently to prepare for their mortgage renewal -- they increased monthly payments and reduced spending elsewhere to free up more cash to put toward debt, said Solovieva.

“Like the proverbial mouse that fell into milk and churned it into butter to survive, Canadian mortgage holders, facing renewals at much higher rates, took pre-emptive steps to reduce the impact to their budgets,” she said.

The actions have helped keep mortgage delinquencies below pre-pandemic levels, and ease the credit concern that was a big overhang to bank stocks.

Concerns about credit are also easing, but will still be a focus as investors look to see to what degree provisions for credit losses are decelerating, said Jefferies analyst John Aiken in a note.

Coming out of the last quarter, banks had set aside about $4.4 billion in total for potential loan losses, up 23 per cent from a year earlier, he said. Given the soft labour market and economy, Aiken expects provisions to peak in the first half of 2025 before slowly trending down.

Rate cuts by the Bank of Canada aren’t expected to significantly bolster personal lending yet, but commercial loans could see stronger growth in the quarter, he said.

“The next lift in the Canadian banks' valuations will likely come when consumer lending growth resumes, which should be as early as in the first half of 2025," Aiken said.

Some of the main pressures banks could face ahead include lower immigration numbers, which analysts will be looking for commentary on from CEOs.

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The presidency of Donald Trump also creates uncertainty, including the potential for tariffs on Canadian imports and the resulting effect on the economy, but banks with U.S. exposure also stand to gain from a looser regulatory environment, say analysts.

Scotiabank kicks off earnings on Tuesday, followed by National Bank and RBC Wednesday. BMO, TD, and CIBC all report on Thursday.

This report by The Canadian Press was first published Dec. 1, 2024.