When it comes to the Canadian banking sector, the last couple of years have been unusual, to say the least. In this blog post, we’ll delve into the current outlook for Canadian banks, explore the challenges they face, and discuss strategies for investors looking to navigate these uncertain waters. The following are my takeaways from a conversation with Gabriel Dechaine, Managing Director Canadian Banks and Insurance Analyst from National Bank Financial

The Unusual Underperformance

One standout trend in the Canadian banking sector is the underperformance of banks in comparison to the broader market. Notably, this has been ongoing for two consecutive years, a rarity in itself. As for three years in a row? That’s uncharted territory as far as we know.

So, why are Canadian banks facing such headwinds? Gabriel Dechaine offers some insights into the challenges ahead:

1. Stringent Regulatory Restrictions: The banks are grappling with increasingly stringent regulatory restrictions and capital requirements. While their current capital levels are robust, these requirements continue to rise.
2. Expense Inflation: Operating costs are on the rise, putting pressure on profitability.
3. Competitive Deposit Rates: Reduced net margins on loans are a concern as deposit rates become more competitive.
4. Stagnant Margins: Although higher interest rates typically lead to improved margins, that’s not the current trend.
5. Sluggish Mortgage Growth: The growth of mortgages has been slowing down, impacting lending income.
6. Rising Impaired Loans: Impaired loan balances are on the rise, which could affect the banks’ bottom line.
7. Mortgage Payment Shock: A substantial portion of mortgages at many banks has lengthy amortization periods, potentially leading to payment shocks.

These challenges are collectively putting downward pressure on bank earnings.

Dividend Dilemma

For income-oriented investors, dividends are a crucial consideration. The good news is that payout ratios remain elevated but sustainable. However, don’t expect robust dividend growth in the near future.

Furthermore, banks are taking measures to bolster their capital positions, which has led to discounts on their Dividend Reinvestment Plans (DRIPs). Share buybacks are not currently a priority for most banks.

Valuation and Yield

Given these factors, Canadian banks are currently trading below-average valuations, with a price-to-earnings ratio of approximately 9.5, compared to the 10-year average of 10.5. Consequently, the average dividend yield on these banks stands at over 5.25%.

The question on every investor’s mind is whether this is a good time to buy. The answer, of course, depends on various factors. Short-term volatility may persist, potentially driving prices lower. Still, for long-term investors willing to weather the storms, this could be an attractive entry point.

Investment Strategies

Now, let’s discuss some strategies for navigating the Canadian banking landscape:

1. Long-Term Entry: Timing the market can be challenging. Consider this a long-term entry point and collect yield while waiting for better times.
2. Cost-Efficient Exposure: Most investors already have or should have exposure to Canadian banks. Look for low-cost solutions to maintain your exposure efficiently.
3. Explore ETFs: Consider these solutions for switches in your current exposures or as additions. Some ETF options include:
   • Horizons Equal Weight Banks Index ETF (HBNK): Offering the lowest cost exposure for Canadian banks, with an annualized distribution yield of 5.31%⁴.
   • Horizons Equal Weight Canada Banks Index ETF (HEWB): A part of the Total Return Corporate Class, suitable for those not needing income, offering tax-efficient growth.
   • Horizons Equal Weight Canadian Bank Covered Call ETF (BKCC): For more income, consider monetizing volatility by writing covered calls, yielding a tax-efficient ~12%.
   • Horizons Enhanced Equal Weight Banks Index ETF (BNKL): Enhanced exposure for bullish investors, offering a higher dividend yield of 6.22%⁴.
   • Horizons Enhanced Equal Weight Canadian Banks Covered Call ETF (BKCL): For those seeking growth and income, it offers a current annualized distribution yield of 16%.

Expert Insights

Gabriel Dechaine’s favourite among Canadian banks right now is RBC, and he highlights that while banks are correlated over time, interim moves can differentiate them. The equal weight exposure strategy, which rebalances twice a year, can help add value by “selling the winners and buying the laggards,” potentially leading to better returns.

Looking Ahead

With deposits continuing to grow, there’s reason to be optimistic about the stock market’s prospects in the coming years. As interest rates start to come down, moving cash back into the markets could present an opportunity in the long term. However, it’s essential to keep in mind that Gabriel’s analysis is focused on the next 6-12 months.

In conclusion, the Canadian banking sector faces challenges, but it also offers opportunities for astute investors. Consider your investment horizon, risk tolerance, and the strategies outlined here when navigating the dynamic landscape of Canadian banks.