Decoding Q2 Canadian Bank Earnings

Daniel Stanley: Welcome to the 15^th episode of our deep dive series on Canadian bank earnings. Today we’re covering the second quarter 2024 bank earnings announcements, and we’re going to return each quarter to this channel to update you on the latest financial results.

My name is Daniel Stanley. I’m an ETF specialist at BMO Exchange Traded Funds. And I’m joined today by my friends and colleagues Chris Heakes, Portfolio Manager for all of BMO Equity and Multi-Asset ETFs and Sohrab Movahedi Managing Director, Financials Research at BMO Capital Markets. Today we’re going to cover the recent bank earnings announcements and what they mean for investors and the Canadian economy, as well as looking at different ETF strategies that give you exposure to the Canadian banks. So without further ado, Chris, and Sohrab, thank you for taking the time to join me. And Sohrab, I want to start off with you. You know last quarter your thesis was that the Canadian banks were at an inflection point. So maybe share with us how did the banks do this quarter? And are the results consistent with that thesis?

Sohrab Movahedi: Yeah, Morning, Good to be back. So let’s see Q2 results. The five big banks that we cover, actually reported year over year higher earnings per share. In the quarter, we were actually expecting a decline, although less of a decline than what we had seen in the first quarter. For us, or at least relative to us, it was a revenue driven beat relative to our expectations. With both expenses and credit provisions, you know, materially coming in, in line. You know, coming out of the results, we’ve kind of made no real material changes to any of our views or ratings. And quite candidly left our 2025 earnings estimates unchanged. So we didn’t think this was a thesis altering quarter. In fact, I think things are going as as we would have envisioned, or as we would have expected, maybe a little bit better, like I said, given the better revenue environment.

And the better revenue environment, I’ll say, you know, we sometimes oftentimes we talk about the revenue diversification of the Canadian banks. And I think it’s worth highlighting that that revenue driven beat was the markets related businesses. So those would be the wealth management businesses, those would be the trading businesses, their capital markets, type activities that have been going through a prolonged there had been going anyway, through a bit of a prolonged lull. We’re not really calling it a shift back to normalization yet, but it certainly does look like those businesses are firming. And I think at a time that we need them to because volume growth, long growth that drives about 50% of the revenues, spread base revenues had been a little bit softer. So net net, I’d say thesis remains intact. I think we are seeing improving year over year earnings trajectory at the banks. And just as a reminder that for 2025 we see the system kind of getting back to around that. I’ll call it plus or minus 7%, EPS growth, which is right around there medium term, target published targets for growth.

Daniel Stanley: That’s great Sohrab. Thank you very much. Chris, I’m gonna turn it over to you because you know, Sohrab mentioned the five banks that we review, the sixth one being our own bank and for obvious reasons Sohrab is really not in position to comment on that. But Chris, I want to talk to you about BMO, because after they reported their quarterly earnings, the the stock dropped almost 10% from roughly $130 to $118. Talk to us were there any other big bank stock moves this quarter and do the moves in ZEB the BMO Equal Weight Bank Index ETF how do those moves compared to the stock moves?

Chris Heakes: Yeah, for sure. Thanks Dan, and good to be here. Unfortunately for BMO shareholders most of the other bank moves were of the positive variety that BMO that BMO move us, you know, unfortunately that one day move kind of puts it in the territory of COVID and in 2008 kind of worst one day price moves of the past 20 years. So, you know, not not the greatest to see but you know, resets happen in stocks, and that’s not uncommon to see that.

Some of the other banks did, you know, fare much better. And I think following along some of the, you know, the optimism and on the revenue side Sohrab was referring to, we saw Commerce Bank up 7% on earnings day, Royal was up 5% national was up 2 1/2%. So you’ve had some good results. Now, I would say commerce largely sold off the next day gave back a good chunk of that seven. But still, you did see some of the some of that optimism come through, you know, the average, the average price move across the six banks, including BMO was, was on modest 0.5%. But again, that’s pretty good when you had one bank dragging, dragging it down with a 9%. Negative. So again, that shows, you know, I think, a few things, but, one is, you know, the power of diversification and using an ETF as a tool to just get exposure to the industry overall. And, you know, certainly there’s going to be some winners and losers on a quarter by quarter basis for sure. ZEB, as you mentioned, kind of delivers the overall exposure. So that can be, you know, easy for some investors. But then the other, the other kind of flip side to that is the opportunity embedded within some of the banks individually. And if you look at standard deviation of those price moves, you know, maybe not surprisingly, the standard deviation was the highest in the past few quarters when you look at the price moves on the announcement day. You know, one area we’ve seen that flow through to is our ZWB. So the BMO Covered Call Canadian Banks ETF, which supplements the the long exposure and Canadian banks by selling call options to generate additional premium. You know, as a reminder, we sell call options on each individual bank. Largely, we do also sell call options on ZEB. But a lot of it’s on the single banks. And that increase in volatility can actually be can be harnessed in a strategy like that to return more cash flow. So more, you know, a little more price swings this quarter, for sure. Positive and negative. And, you know, and again, you can use two ETFs and different ways to, to harness that.

Daniel Stanley: That’s great. Thanks, Chris. Sohrab, I want to come back to you. And I want to come back to the issue of provisions. And you sort of said provisions were sort of in line with expectations. You know, when I was reading the reports that were coming out afterwards, it did seem like the theme was that most of the banks were still increasing provisions if I’m not mistaken, and that it was affecting earnings. But again, from your perspective, is this a big risk going forward? Or?

Sohrab Movahedi: Yeah, so excuse me. So when we think about these provisions, that mean, the best way to think about it is probably both what you’re charging to the income statement, and then what sort of reserves you’ve built, if you will, on the balance sheet. And the way good lending works is you try and replenish your reserves, when you earn, you have write offs. And so in the context of the banks will think of performing, let’s call it credit reserves and impaired credit reserves impairments, of course, being you know, degradation in credit quality in the context of a commercial portfolio could be a borrower that, you know, gets downgraded heavily or maybe even misses a payment in the case of consumer or retail lending portfolios, it could be driven off of higher unemployment rate, or it could be you know, higher interest rates or, or what have you that kind of impact the broader portfolio of a homogeneous portfolio, very small credits. The banks in Canada would have done significant reserve building on their performing loans. If you go back all the way to COVID, there was an Off The Charts type event, so there was lots of fair reaction to it. But the impairments actually ended up not spiking at the same rate that reserve building had reacted. And perhaps that was a reflection of a lot of stimulus spending and the government programs that had been in place to retain kind of the economy. So yeah, would have seen some reserve releases, for example, again, off the performing bucket as opposed to the impaired bucket. I think for the past seven or eight quarters, what you’ve seen is banks, adding, if you will, to their performing bucket anywhere from one to four or five basis points. Above and beyond the impairment expense. Instead, they’re having in so this quarter, you know, as a group of five, they would have done about 44 basis points. So this would have been the total provision that they would have taken to the or charge to the income statement, you know, largely speaking, around 39 of that would have been against the impaired book, and about five of that would have been further reserve building. So I think what’s important to take into account here is reserve building will plateau at some stage, when we’ve seen impairments peak. Okay, so I think good, again, good reserve building and balance sheet, management would probably say, let’s not deplete our reserves until we’ve seen the worst of it. And I think that we’re near the peak. I think CIBC might be a good example of a bank that, for example, a year or a year and a bit ago, went into the credit tunnels specific with the office commercial real estate issue, had to take some reserves earlier than their peers. And I think this quarter, we got a message of reserve building, but at a at a more moderate pace, if you will. And while we’re not really calling the peak on impairments, that you could almost argue that impairments look to be plateauing or are near the peaks probably for this cycle. So I think reserves look still adequate to us relative to ultimate ultimately, and no recession scenario, right? I mean, I think you don’t always can, you’re not going to be more reserved for the full, you know, gamut. But from a probability weighted perspective, I think, given the likelihood of rates coming down, perhaps, you know, no concerns from a recession and economic slowdown type perspective, that would spike unemployment rates. For example, for the Canadian banks, we would say the reserves are adequate. And of course, another important measure of balance sheet strengthened, and the like for the banks would be the capital ratios that they have, and all very healthy 13% plus Royal Bank, the largest bank in the country, they closed on the HSBC Canada acquisition in March. So April would have been the first time they would have reported the results inclusive of that HSBC acquisition, and I thought was what was probably just as encouraging sign, perhaps foreshadowing was that with a 12.8%, cet one ratio, they did announce a normal course issuer bid. So they would like to do some buybacks about 2% of their book. And I would argue that if a bank sitting with about 12.8%, obviously they are one of the higher ROE banks, so they have some good visibility into their internal earnings generation and capital generation. But they must have a more optimistic view, or perhaps less of a pessimistic view on the credit outlook if they’re willing to actually start spending some of that capital, even, even right now. So my read of the announcement of Royal Bank actually would suggest that they to anticipate seeing peaks in the impairments perhaps by the end of this fiscal year, and and that in the balance of probability of outcomes, you may actually even see some reserve releases in 2025, all of which I think, would say, We’re not calling it the end of the cycle. But we certainly feel like we’re very near the end of the cycle.

Daniel Stanley: Well, thanks, Sohrab. No, that’s helpful. It’s a good segue into my next question, because you talked about, you know, central banks. And, Chris, I wanted to ask you this question. Sohrab, feel free to chime in afterwards, as well, if you’d like to, because it is a more macro question. But it’s a question about the Bank of Canada, which lead the group of seven central banks and reduce the overnight rate by 25 basis points. That was last week. You know, Chris, how do you see that impacting sort of broadly the operating environment for the banks and hence sort of impact on ZEB the equal weight bank ETF?

Chris Heakes: Yeah, for sure. Thanks, Dan. And, yeah, Canada was the first to cut rates, they beat the ECB, the European Central Bank by one day, so but we did get the gold medal in terms of the first rate cut there. I think Sohrab laid it out, you know, really well, and I think from a macro perspective, you know, it’s really going to come down to you know, where we’re at in the cycle and, and that softness of the land, and we talked about soft landings, no landings, you know, harder landings and I think I think that’s going to be a big one. But you know, in the short term, certainly the lower interest rate the cut was was well received generally, you know, mortgage seekers mortgage renewers, anyone personal commercial borrower. It’s obviously, you know, relief there and stimulative. You know, the thing I think to consider is, you know, it is it’s a bit of a double edged sword. You know, the Bank of Canada acknowledged spare capacity as being part of the reason why they didn’t have to be as restrictive and gave them that ability to cut rates. You know, we’ve seen some mixed underlying, mixed underlying data coming out of Canada, the GDP, you know, as a small, small miss to the downside, you know, jobs has been mixed. And, you know, we keep hearing about the productivity crisis in Canada. So, you know, you’re taking taking a step back, you know, this bank rally that kind of kicked off in November largely call it obviously, it’s not gonna straight one way up. There’s been some choppiness, but it was really predicated on on lower interest rates. Canada, we are getting that and it looks like there’s more to happen and 2024 the markets pricing in two more for the rest of the year. And I think the governor was, you know, you know, all but saying there’s probably more happening, don’t expect don’t expect them all at once, but there’s likely more to happen. So the read through to Canadian banks, I think on the Canadian side, is there still some potential choppiness? I think it’s, you know, that state of the economy impacts, you know, to Sohrab’s point, the performance of the loan bucks, and that’s going to have, you know, that’s going to probably be the big driver, and Canadian banks are always at that bellwether of the Canadian economy. But from a long term prospective, you know, there’s a lot of things to like in that 5% dividend yield, you know, does does pay you to wait. And I think that 5%, dividend yield also becomes a lot more attractive as interest rate falls, you know, as we get if say, we get to more interest rate cuts, not overnight rate trends towards 4%. Well, 5%, on, on Canadian banks, you know, it’s attractive, you know, I think we’re, you know, just touching on the US setup, it’s a little bit different in the US. You know, and we’ll just touch on that. But, you know, the US market, we’re expecting six cuts to start the year, it’s less than two that are expected, and they’re proving very difficult to come by, you know, the economy running much, much stronger overall, in the US, the consumer being more strong. So that higher for longer interest rates, story is still in place. Now. However, though, you know, regarding banks, I think that soft landing or no landing scenario seems to be more kind of consensus, playing out amongst investors, and given what happened to banks last March, and us with a banking crisis, they’ve had a lot of room to recover. You know, we’re even seeing some fast money go into the US banks trying to benefit from a possible Trump election, we’re not gonna I’m not going to wade into that one today. I don’t think we got the time or the maybe the time to get into the the election issues, but we are seeing some some Fast Money want to get in front of that potentially. But again, in the US, it’s kind of a different setup, you’re maybe not getting the rate cuts, but you’re getting a softer and softer landing, potentially, you know, landing and that’s better for the for the credit cycle. I think so those that’s kind of how it ties up the two to two markets. And so certainly choppiness but you know, from a long term perspective, I think it’s, you know, you know, it’s looking more constructive.

Sohrab Movahedi: Again, it’s Sohrab. If I could just add some incremental perspective, to the the yield concept that I think Chris was talking about, obviously, Canadian banks, you know, the dividends are an important ingredient ingredient to the total return story. You know, the one bit of observation I’ll share, and we’ve published on this, when you look at the, you know, the latest rate hike cycle, drove quite a bit of funds into term deposits GICs, for example, in Canada, presumably because they would have been higher yield, with with less risk associated with them. And an interesting observation I chair over here is we looked back about 20 years when went back to January 2001. And we looked at previous rate cutting cycles. So when rate cuts first started, and obviously, you know, these are, it’s hard to be definitive about them. But when you look at the number of months, it takes from the first rate cut to when you see term deposit balances at the banks to start kinda coming down or you have net outflows, if you will. It’s about five months. Now, the interesting thing I’d say is, you know, one argument I could make that some of that money started to flow out of GICs is because the rates that you’re getting on those who are looking less enticing, let’s say relative to, for example yields that you could get elsewhere. So what we did is, we looked to see what happens when that term deposit money balances, you know, you have the net outflows, you know, how long before actually the Canadian bank index starts showing out performance relative to the TSX. And, from the first outflow, so five months since the first rate cut, six months hence. So we’re now looking almost a year out, the bank index has has on average outperformed by 11,000 basis points. Okay, so over the ensuing six months, so, to me, and, you know, to the work that we’ve done over here that lines up quite favorably, and consistently with our more optimistic outlook towards not only the second half of 2024, but towards 2025, as well. So I just share that as a bit of a data mining exercise, and nothing more. And obviously, lots and lots of factors go into it. But it’s just a reminder about the attractive yield play that, that the banks are and that how that yield play has been less of a factor, as you know, as risk free rates had kind of run up quite aggressively in the recent past.

Daniel Stanley: No, that’s great. Sohrab thanks for that insight are really very much appreciate it. Chris, and Sohrab, I want to take a step back and take sort of a more macro question to close things off again today. Chris, we’ll start with you. And then Sohrab, you can finish this off. But you know, guys, the Canadian banks, of course, are a massive component of the Canadian economy. They’re, they’re heavily influenced by it. Look, if you just take a step back and take a bird’s eye view of Canada, and if you’re looking at the banking sector, what are some of the reasons to be optimistic as a shareholder as we move into the third quarter? And maybe some reasons to be concerned?

Chris Heakes: Yeah, so maybe this is kind of a reiteration. But I just started saying, you know, we’re seeing the interest rate cuts coming through potentially two more this year, you know, that’s rate normalization, that’s also going to kind of reset the credit cycle. And, you know, some of the comments on terms of potentially the banks being well positioned around that already, I think are important. But that’s, you know, bird’s eye view that helps Canada, you know, there’s other segments of the Canadian market that have also kind of really suffered, in my opinion, with the higher interest rates and some of the traditional defensives, like utilities, real estate, telecoms, you know, have not been strong equity market performers. You know, I think with the Canadian banks, you know, they they benefit from strong overall Canadian economy and all sectors of the economy. So, potentially a bit of a, you know, a bit of a lift in some of those sectors off the back of interest rate, cuts, you know, helps the banks overall helps the overall Canadian economy. We talked about the bank yield at 5%, that’s becoming more attractive, again, and not to rehash but the well diversified business streams. You know, and well kept, you know, strong capitalization always helps, you know, last thing, maybe I’ll just mention is the market valuation. And, you know, there’s a lot being talked about, say US market valuation, price earnings on the S&P 500 or around, you know, 22 on a forward basis, you know, Canada’s 15, and banks trade kind of well below that as well. So, you know, in terms of Canada, and that kind of, kind of more larger playbook. and Canadian banks specifically, I think there’s, you know, there’s more room to be constructive. I think the negative at this point, and, you know, a lot a lot of things that should work over the long term.

Sohrab Movahedi: Chris, what I’ll, maybe I’ll build on that. And I’ll say that Let’s let’s look back first before we look forward, and I think if we look through 2023, it was a particularly difficult year, right from 22 to 23. Canadian banks were dealing with higher regulatory capital requirements, I think, you know, we forget, but our regulator here increased the domestic stability buffer twice. That’s 100 basis points add to the, to the capital requirements. And some of the banks had to basically introduce these drip discounts to kind of issue some equity on a, on a consistent basis. They were doing that, at a time where the markets related businesses were going through a prolonged period of lulls so that your revenues, at least half of the revenue stream was not really growing. They were doing that at a time where they were still digesting the remnants, if you will, after, you know, we don’t even talk about it, but it was the great resignation, and how all companies including banks, probably over higher than how to actually pay up to retain some employees. So you had the impact of inflation plus a bit of a bloated expense space. And they were doing all of this at a time that they were significantly beefing up their credit reserves, in anticipation of a tougher economic outlook, just the impact of higher rates on their borrower credit quality. Now, that is a trifecta if not, you know, four factor type headwind coming at you, that was something that the banks had dealt with materially through 2023. Now, some of the banks have not, you know, have only turned off, for example, the drip discounts halfway through this year, we are actually rather optimistic that the reserve building that has happened, will serve them well. So I want to be clear on one thing, we’re not trying to say there is a shift in the economy, what I can, what we’re trying to say is the nature of the Canadian housing market, the typical five year term of mortgages, has required many bank mortgage holders and therefore loan portfolios to establish a degree of the best way maybe to put it is a lot of borrowers have acclimatized to this rate environment. And we’ve seen the negative impact of that from a, from a discretionary spending perspective, and what have you. So like, Chris was talking about if rates are coming down, if that actually creates a little bit of incremental capacity for those borrowers, perhaps, you know, $100-150, less a month, in mortgage payments, those are net additive, if you will, to an economy that has been actually feeling the contraction, for the better part of a couple of years, you know, eight quarters of reserve building is, is quite a bit of headwind that I think has been absorbed for the bank. So, you know, as we sit here today, you know, a month or so ago, going into the results, I would have said, you know, the market cap of the Canadian bank index, I think, on May 14, I measures that was $620 billion coming out of the results, and maybe having had a week, or 10 days for the dust to settle, which still sitting around $620 billion. So there’s been some puts and takes between the banks, but the market, the pie hasn’t actually grown. And you know, that, you know, we need that number to start kind of growing when non domestics start coming to Canada, the Canadian banks get more than their fair share of that funds flow. And, you know, we’ve talked about this, I think, in the past as well, non domestics, that net outflows from Canadian equities by non domestic investors probably is at a two decade high. So these are all signs of really bad times. The question is, do we go or? Excuse me, or do we start getting better? And I think, you know, our inclination is to think that we’re starting to get, we’re coming through the light that we see is indeed the end of the tunnel. And so we’re a bit more optimistic. And so I would expect if not, next quarter, then in the next couple of quarters, the proportion that the bank’s representative, the Canadian bank index has increased from I don’t know, sorry, from the overall market has increased from 18% to 19% to 20%. And hopefully we get to over 20% by sometime a year or so from now. So that’s the that’s the positive pitch that I think, you know, we would like to leave our listeners with today.

Daniel Stanley: No, thanks, guys. Chris, Sohrab. That’s a great way to end it. I think, you know, Sohrab, despite that trifecta of challenges that you brought up, you know that Chris, you’ve talked about the dividend yield five percents, and at the end of the day there’s the challenges of the outflows from foreign investors but but at the end of the day, to your point, Sohrab, we’re closer to the end here and that that is a great way to end off today’s podcast. So Chris and Sohrab Thank you very much. Just as a quick reminder to the audience, you can get exposure to the Canadian banks via ZEB, the BMO Equal Weight Bank Index ETF as well as ZWB the BMO Covered Call Canadian Bank Index ETF or you can get exposure to our US banks ETF ZUB, ZBK, which are the BMO Equal Weight US Banks Index ETF. If you have any questions, please visit the ETF Center at bmoetfs.com. That’s all for today, folks, thank you for tuning in. And please join us in mid September for the next update on Canadian banks.