The Canadian banks will survive; but they won't thrive

Analysts from outside of Canada are downgrading Canadian banks in the aftermath of precipitous drops in the Canadian dollar and crude oil. The downgrades are triggered by the slowing Canadian economy and the collapse of the energy sector. One downgrade, on January 30, by Barclays (an investment bank based in London England), was justified by research analyst John Aitkens: Canadian banks face a slowing Canadian economy, compressing net interest margins and stagnating consumer loan demand, according to a Bloomberg report (BNN link that discusses Barclay's downgrade).

So what does the future hold for shares of Canadian banks?

This is Part I of a three-part series on Canada’s banks.

Canadian investors own shares of Canadian banks in large quantities, with banks being the biggest investment in most cases. This is true for Canadian pension plans, most mutual funds and institutional investors also. So it’s crucial for 2015 and 2016 investment performance to determine what the future holds for profits and share prices in the financial sector. How will the Canadian banks perform, since they are generally focused on lending to Canadian households and businesses?

Canada’s banks make up more than 25% of the Canadian stock market as the biggest component in the financial sector. According to Credit Suisse, Canada’s ten financial companies, including the Big Six banks, are about 36% of the weighting in the S&P TSX index. The long-term average weighting is about 31%, so the concentration is at record highs. The second largest sector, energy, was 25% of the TSX in the middle of 2014 but is now at 22% and probably headed toward 20% or lower.

Looking at earnings, we find that the financial sector is even more important as profits from banks and other financials make up approximately 45% of total TSX earnings. With the collapse in earnings from the energy sector the profit share of financials will surpass 50% in 2015, in all probability. Since the bulk of profits in the financial sector are from banks this means that the Canadian stock market can be considered a “play on Canadian banks”, absent a sudden return of $100 oil, and that’s not going to happen.

So it can be said, for the next year -- As go the banks, so goes Canada’s stock market!

What is the outlook for Canadian bank profits?

Well, the outlook isn’t good, as the Canadian housing market is about to go through a major correction. As I discuss in my book, “When the Bubble Bursts: Surviving the Canadian Real Estate Crash,” coming in March 2015, the Canadian banks will survive but they won’t thrive. The reason that banks’ earnings performance will disappear is simple; their outstanding performance as measured by earnings, dividends and share prices in the last twenty years (Royal Bank’s share price was up about ten-fold from 1995 to 2014) has been driven by an unprecedented and unsustainable surge in Canadian household debt. And, of course, household debt is repaid out of the salaries and wages of Canadian workers and is backed by real estate collateral, usually owner-occupied homes and condos but also second and third properties such as condo rentals or cottages. When that real estate value starts to decline the banks’ loan growth will grind to a halt or even go into reverse. And, of course, if there is a recession, Canadian wages will take a hit and the banks will be suffer loan losses and a shrinking asset base.

But Canadian banks are currently priced to perfection with a share-price-to-book-value of 1.5 to 2.4 times compared to a global average for banks of about 1.1 times book value. Large European banks can be purchased for 0.5 to 0.7 times, a bargain price due to investors’ worries about Russia and Greece. US banks’ share prices averaged in early 2015 about 1.2 times book value. In 2005, prior to the US housing collapse, US banks traded at similar extreme multiples as Canadian banks trade today, more than 2.2 times book value.

Next week I’ll look at more specific reasons why Canadian bank shares are unlikely to trade at such elevated levels for much longer.