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Forget About the Threat of a Recession: Canada’s Big Banks Will Continue to Perform

Canada’s Big Six banks have been a popular target among short-sellers since the end of the Great Recession around a decade ago. While a range of fundamental indicators, including near-record levels of household debt, weaker-than-anticipated economic growth, and a softer housing market point to a reckoning for the banks, the trade has generated tremendous losses for short-sellers.

Even the claims of famed short-seller Steve Eisman, who stated in June 2019 that the banks were facing a normalization of the credit cycle, which would sharply impact earnings, has yet to be proven right. In fact, some short-sellers believe that the conditions faced by Canada’s banks are like those that led to the near collapse of the U.S. financial system as the housing bust and Great Recession unfolded in 2007.

How bad is the outlook?

While there are certainly headwinds ahead, the outlook is not as bleak as short-sellers would have investors believe. A combination of tight prudential regulation, lack of subprime loans, mortgage insurance, and conservative loan-to-valuation ratios (LTVs) illustrate that the banks are nowhere near as vulnerable as believed. The latest third-quarter 2019 results were also stronger than many pundits anticipated, indicating that the impact of various headwinds on the big banks’ performance were not as severe as predicted.

Royal Bank of Canada (TSX:RY)(NYSE:RY), which is the fourth most-shorted stock on the TSX, reported a 5% year-over-year increase in net income on the back of higher net interest income and greater efficiency. Despite the bank’s return on equity falling by 0.6% year over year, it was still an impressive 16.7%, which was the second highest among the Big Six, coming in behind National Bank of Canada’s (TSX:NA) 18.6%. This demonstrates that the even in the current difficult operating environment, both Royal Bank and National Bank are delivering considerable value for shareholders.

Royal Bank’s gross impaired loans ratio of 0.47%, which is only 0.03% greater than National Bank’s 0.44%, illustrates that credit quality remains high. It underscores that it would take a disastrous decline in loan quality have a marked impact on the balance sheets of Royal Bank or National Bank.

It important to note that 36% of Royal Bank’s mortgages are insured, and those that aren’t insured have an average LTV of 52%. This will significantly mitigate the impact of a weaker credit cycle on the bank’s business triggered by worsening economic conditions. In the case of National Bank, which emerged as the best performing of the Big Six, despite its exclusively domestic focus, 40% of its mortgages are insured while the remaining uninsured loans have a conservative LTV of 58%. Those numbers for each of the other Big Six banks are similar, highlighting that they are all quite resilient to a weaker economy and deterioration in credit quality, meaning that their values won’t collapse as the short-sellers claim.

Foolish takeaway

Regardless of the current short-term headwinds and fears of a recession, Canada’s big banks will continue to grow strongly over the long term. For the reasons discussed, Royal Bank and National Bank remain two of the best banks to buy. After being marked down by the market since last month, because of a higher perceived degree of risk, both appear attractively valued, making now the time to buy. Royal Bank and National also pay sustainable dividends yielding 4%, which will reward patient investors as they wait for the economic cycle to improve and their stock to rally.

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Fool contributor Matt Smith has no position in any of the stocks mentioned.

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