TD Bank (TSX:TD) picked up a nice tailwind in the past few weeks. Investors who missed the recent bounce off the 12-month low wonder if TD stock is still undervalued and good to buy for a self-directed Tax-Free Savings Account (TFSA) or Registered Retirement Savings Plan (RRSP).
Economic outlook
The Bank of Canada and the U.S. Federal Reserve continue to raise interest rates in their battle to get inflation back down to their 2% target. Higher rates make borrowing more expensive. This drives up debt costs for businesses and households. The theory is that soaring rates will force a reduction in consumption and slow down the hot post-pandemic economy. As demand for products and services falls, businesses will need fewer employees. The drop in job openings should reduce the upward pressure on wage rates.
In the past month or so, the market has begun to believe that the central banks might actually be able to navigate a soft landing for the economy as inflation subsides. This is one reason bank stocks are moving higher.
During much of the past year, investors feared that the steep rise in interest rates would trigger a major economic slump. In that scenario, the tight jobs market could shift to a surge in job losses and higher unemployment. This would put more households in financial trouble and consequently hit the economy even harder.
Banks normally benefit from higher interest rates because they can earn better net interest margins. In regular conditions, this should offset the increase in loan defaults. However, the sharp rise in rates that has occurred in such a short timeframe could potentially unleash a wave of bankruptcies. Banks are already boosting provisions for credit losses, but the increase is still relatively small. A situation where commercial and residential property loans go bad on a massive scale would be bad news.
Savings built up during the pandemic and a surge in immigration are helping the economy, and the housing market ride out the impact of higher interest rates. It might be too soon, however, to break out the party hats and celebrate a soft landing. Rate hikes take time to work their way through the system. The longer that rates stay elevated, the higher the risk of a sharp economic downturn. At some point, households and businesses will burn through their excess cash. Fixed-rate borrowers who have avoided the pain so far are increasingly being forced to renew mortgages at higher rates.
Should you buy TD Bank stock?
TD trades for close to $87 per share at the time of writing compared to $77 two months ago but is still down from the 2023 high of $93 and the 2022 peak around $108.
TD is sitting on a mountain of excess cash after it cancelled its planned US$13.4 billion acquisition of First Horizon, a U.S. regional bank. This means TD has adequate capital to ride out a downturn, so investors shouldn’t worry about the bank getting into financial trouble.
TD is using some of the extra cash to expand in key U.S. markets by opening dozens of new branches. In addition, TD is buying back stock. Investors should see a dividend increase before the end of the year. Another acquisition could also emerge while pockets of the bank sector remains out of favour with investors and valuations sit at low levels.
The easy money has likely already been made, and ongoing volatility should be expected, but TD still looks attractive at the current price for buy-and-hold TFSA or RRSP investors. At the time of writing, TD stock provides a 4.4% dividend yield.
