Why Canadian Bank Stocks Like TD Bank (TSX:TD) Are Vulnerable Today

Toronto-Dominion Bank (TSX:TD)(NYSE:TD) stock is among the Canadian banks that are facing a challenging environment of declining net interest margins and increasing loan losses, so investors should be cautious as we head into 2020.

Road sign warning of a risk ahead

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Canadian banks have historically provided their shareholders with very generous (and growing) dividend income, capital gains, and, most of all, security. Shareholders of Canadian banks have not lost any sleep but have instead enjoyed a steady increase in wealth because of their investment.

After surviving — not thriving — despite the historic financial crash in 2008 and low interest rates thereafter, investors may have come to believe that Canadian banks will not falter. Given the macro environment that has been taking shape over recent years, is this, in fact, true?  Are there vulnerabilities in Canadian banks that are seething beneath the surface and that are just a heartbeat away from bubbling to the surface?

Bank stock prices have recovered once again from the lows this summer and are closing in on their highs, but with the next quarter’s reporting season quickly approaching, investors should be prepared for lower-than-expected results.

Low (and falling?) interest rates = margin compression

Canada has recently decided to keep its interest rate at 1.75%, and while this is significantly higher than rates that were well below 1% in the years following the market crash, there is once again downward pressure. In fact, the U.S. Fed lowered its interest rate by another 25 basis points last week, the second cut since July, in what is reflective of its aggressive stance on lowering rates to combat signs of a weakening U.S. economy.

With the highest proportion of U.S. revenues, Toronto-Dominion Bank is seeing the negative effects of falling U.S. interest rates. In its latest quarter, the net interest margin declined 11 basis points versus the prior quarter, and while EPS was in line with expectations, there were once again unmistakable signs of many challenges ahead.

While the banks have flourished in spite of the low interest rate environment largely due to solid expense management and the rapid increase in mortgages and loans, the consumer is heavily indebted, and we are seeing increasing non-performing loans and provisions for loan losses (PCLs). This signals rough times ahead, as the banks tackle yet more possible rate decreases, a further narrowing of net interest margins, and pressure on earnings.

Unsustainably high debt levels = pressure on loans

Canadians remain highly indebted. According to Statistics Canada, Canadians’ debt-to-income ratio rose to 174% in the second quarter of 2019 — a level that has kept rising and that places households at risk. This, in turn, places banks at risk. Credit ratios will deteriorate, and loan loss provision will rise. We have already seen this in recent quarters, and this should serve as a warning signal to investors.

Last quarter’s warning signs

TD’s second-quarter results showed that its PCL ratio declined one basis point versus last quarter, but that the trend remains concerning.  For the first nine months of the year, TD reported a four-basis-point increase in PCLs.

Slowing loan growth remains evident in Canadian Imperial Bank of Commerce’s results. Management has stated that the slowdown in mortgage and real estate loans was more dramatic than they had expected, and that we should expect the environment to remain challenging. CIBC’s provisions for credit losses was up sharply in the third quarter, up 14% sequentially and 21% versus last year, reflecting weakness in the oil and gas loan book. Expectations are for PCLs to rise modestly in the next few years.

At least CIBC’s U.S. acquisition continues to do well, with revenues up 15%, but net interest margins declined one basis point compared to the last quarter, and the pressure will continue.

Foolish bottom line

In this article, I have looked at why Canadian banks may be a house of cards, vulnerable in the current macro environment of low interest rates and record debt levels. While Canadian banks have maintained their capital strength and continue to provide generous dividend income for shareholders, I argue that bank stocks have far to fall if the concerning trends continue. As investors, lightening up on bank stocks would be a reasonable reaction to these developing problems.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Karen Thomas has no position in any of the stocks mentioned.

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