Transcript: Recent ramp-up in loan-loss provisions could peak this year

Risks on the horizon

JB: For banks, the most significant risk factor always remains the potential for higher-than-expected loan-loss provisions. We saw loan losses ramp up very quickly during the pandemic lockdowns. And then the banks benefited when the impact turned out to be less than expected, and they booked a lot of recoveries. Since that time, I would say the credit cycle has become more negative again and the banks have been building loan-loss provisions. So the key is when do those loan losses peak, and can they peak higher than what people are expecting.

Where he sees opportunities

JB: I would highlight two stocks that we own. The first is Bank of Montreal. It completed a transformative acquisition in the United States immediately before one of the worst U.S. regional banking crises in memory. It is now truly a U.S. super-regional bank. And BMO valuation is inexpensive. The other one I would highlight is TD Bank. No Canadian bank has been more in the news, with its anti-money laundering issues. There’s been significant regulatory penalties imposed on them. They’re subject to, really, an indefinite asset cap in its U.S. business. And the question is, is this a permanent impairment? Well first, 70% of TD’s business is not impacted by this asset cap. In fact, TD’s Canadian businesses are executing well. TD is trading at about 1.3 times book value, quite similar to Bank of Montreal. And this remains one of Canada’s leading financial services franchises. Most importantly, TD’s low-cost deposit base remains the envy of the Canadian industry. TD’s U.S. anti-money laundering issues are very real, but they are addressing it. There’s no guarantee of success in this, but TD’s valuation is already assuming that they are unsuccessful. And that provides us downside protection, while at the same time giving upside if they do emerge.

The impact of falling rates on the financial sector

JB: If the Bank of Canada cuts rates, it’s possible that net interest margins are compressed. But at the same time, a reduction in rates is likely to stimulate loan growth. So there’s a natural offset between the two. We’re always reluctant to forecast short-term net interest margins as there are so many factors that can affect them. But bank margins really have been remarkably stable through time, particularly for those banks that have large low-cost deposit bases. If the Bank of Canada cuts rates, that should be positive for mortgage rates. And it’s going to reduce renewal costs for the significant percentage of Canadians who have mortgages renewing in the next couple of years. And that should be positive for the economy in general. We can’t forecast real estate markets — but if there is strong activity that should absolutely be positive for mortgage underwriting and for mortgage loan growth. I would add, though, that mortgage margins have been squeezed in Canada over the last several years. So just because there’s significant mortgage loan growth, it may not translate as directly into an improvement in profitability.

And, finally, what’s the bottom line for the financial sector in the current moment?

JB: I would just say to focus on fundamentals, and look at what is priced into stocks, versus what reasonable outcomes are. Both in TD’s and BMO’s valuations, there’s significant pessimism priced in, relative both to their own histories and to add to the sector. And we think they both offer good value.

Well, those are today’s Soundbites, brought to you by Investment Executive and powered by Canada Life. Our thanks again to James Black of Beutel Goodman Investment Counsel. Visit us at investmentexecutive.com, where you can sign up for our a.m. newsletter and never miss another Soundbite. Thanks for listening.

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