Big Canadian bank stocks could remain as core holdings in diversified portfolios. Canadian investors can focus on safe dividend income generation and long-term investing in the stocks. For a bigger picture, you can observe BMO Equal Weight Banks Index ETF (TSX: ZEB), which is comprised roughly of an equal weighting in the Big Six Canadian bank stocks and has declined about 11% year to date.
ZEB data by YCharts
What is weighing on Canadian bank stocks?
Risks
Some financial system risks could impact the economy and the profits of Canadian banks. They include risks of a housing market downturn, liquidity and funding, commercial real estate, and corporate and commercial credit. Canadian investors should be aware of them.
The rapid increase of global interest rates has increased the financial system risk, but Canada’s financial system remains resilient. For example, the regulator, the Office of the Superintendent of Financial Institutions (OSFI), has put capital and liquidity requirements in place for federally regulated financial institutions, including the big banks, since the Global Financial Crisis of 2008-09 to improve the defensiveness of the Canadian financial system in challenging environments.
Since a meaningful chunk of the Canadian banks’ business is in residential mortgages, a housing market downturn would put pressure on the bank results. In a recent report, OSFI noted that “mortgage holders may not be able to afford continued increases on monthly payments or might see a significant payment shock at the time of their mortgage renewal, leading to higher default probabilities.”
Higher interest rates have triggered a re-rate in assets as well as weighed on liquidity and funding conditions. It has become harder for businesses and individuals to take out loans. Banks also have higher funding costs as short-term securities like government bonds have become competitors for deposits in a higher interest rate environment.
Higher interest rates and capital tightening also make it riskier for commercial real estate and corporate and commercial clients to operate as projects that were attractive before don’t look so attractive now, especially if they’re exposed to variable rates or when it comes time for debt refinancing.
Higher rates increase loan-loss provisions that cut bank earnings.
Conclusion
Today, even the worst-performing Big Six Canadian bank remains highly profitable, with its dividend covered by earnings with leftovers. In the worst-case scenario, it’s possible that the big banks would freeze their dividends, like they did around the global financial crisis or the 2020 pandemic. Collecting the dividends is an important part of the return for investors in the bank stocks.
Although a challenging operating environment is likely to persist going into 2024, the big Canadian bank shares could still be opportunistically bought by long-term investors. It will be helpful for investors to focus on the income generation rather than on the stock price. Only care about the stock price when you plan to buy or sell shares.
Notably, the sixth-largest Canadian bank, National Bank of Canada, has been the most resilient big Canadian bank stock across multiple periods. The most conservative investors looking to add money in the sector could take a closer look at the name.
