RBC Canadian Financial Services Beacon
Investing in Canadian banks ahead of a credit cycle
Event
Many factors that depressed stocks have improved since mid-March, and
bank stocks have rallied as a result. We maintain our view that investors
can be patient and do not need to be buying Canadian bank stocks
aggressively.
• We believe that the Canadian banking system is healthier than the U.S.
banking system, but we believe that share price appreciation will be held
back by: 1) credit deterioration, 2) the potential for negative earnings
revisions, and 3) high P/B valuations relative to banks worldwide and to
prior troughs.
• We believe that banks are at a turning point after many years of below
average loan losses. The deterioration of credit quality that started in early
2006 accelerated during Q1/08. We expect credit losses to continue to rise
in 2008 and 2009 as it is becoming increasingly evident that credit problems
are likely in many areas of U.S. lending, business lending in Canada and,
potentially in 2009, higher consumer loss rates in Canada.
• We have reviewed our earnings estimates to reflect rising concern over
loan losses and have lowered our estimated 2009 EPS for some banks.
Our 2009 earnings estimates are below consensus estimates for Scotiabank,
CIBC and National Bank.
• We believe that the differentiation between the banks and bank stocks
will not be as high in the next 12 months as they have been in the last 12
months. Exposure to credit deterioration and relative earnings growth will
play a greater role in stock price performance in the next 12 months rather
than exposure to capital markets writedowns, in our view.
Of the more expensive banks on a P/E basis (Scotiabank and TD Bank),
we believe that Scotiabank is more susceptible to a derating and we are
lowering our investment rating on its shares to Underperform from
Sector Perform.
• The bank has done a good job of largely avoiding exposures to structured
finance, and we believe the bank has above-average medium- and long-term
growth prospects compared to its peers due to its presence in Latin America
and the Caribbean. However, we do not believe the bank is as well
positioned in a deteriorating credit environment, it is more exposed to rising
wholesale funding rates and the impact on its earnings of a high Canadian
dollar is greater.