TD Bank (TSX:TD) and Royal Bank (TSX:RY) are down considerably from their 2023 highs. The pullback has contrarian investors wondering if TD stock or RY stock is now oversold and good to buy for a self-directed portfolio focused on passive income.
Bank stocks outlook
Rising interest rates are normally good for banks. As rates move higher, the banks can often generate better net interest margins. Over the past 18 months, however, the dramatic increases in interest rates by the Bank of Canada and the United States Federal Reserve have put a lot of borrowers in a difficult position. Those with variable-rate loans have to come up with more cash every time rates increase. Fixed-rate borrowers get hit when their loans come up for renewal. The result has been a surge in provisions for credit losses (PCL) at the banks, as they set more cash aside to cover potential bad loans.
Rate hikes are designed to cool off the economy and bring the labour market into balance as a means of getting inflation under control. Inflation peaked at around 8% in Canada in June 2022 and came in at 3.8% for September 2023. That’s still above the 2% target, so interest rates will likely remain at their current level for the coming months unless there is a meaningful inflation change heading into next year.
Rate hikes take time to fully impact the economy. The concern among investors is that the central banks have actually been too aggressive and will keep rates elevated for too long. In the worst-case scenario, the economy will slip into a deep recession before the central banks start to reduce rates to ease the pain. In that situation, bank stocks could be in for a rough ride.
Economists broadly expect a soft landing to occur for the Canadian economy. They point to a strong jobs market and high immigration levels as pillars of support. At the same time, they say robust housing demand and limited supply should keep residential property prices from crashing.
Where things end up is anyone’s guess, but TD and Royal Bank already appear priced for an ugly outcome.
TD Bank
TD is Canada’s second-largest bank, with a current market capitalization of nearly $147 billion. The stock trades close to $81 at the time of writing compared to $93 in February.
TD has large retail banking operations in the United States and intends to grow the American business organically after it cancelled the planned US$13.4 billion takeover of First Horizon earlier this year. The move forced TD to reduce its earnings targets for 2023, but it also left TD with a war chest of excess cash to help it ride out tough economic times or look for other deals in the bank sector.
TD now trades for close to 10.5 times trailing 12-month earnings and provides a 4.75% dividend yield.
Royal Bank
Canada’s largest bank by market capitalization is trying to get its $13.5 billion acquisition of HSBC Canada across the goal line. The government will make a decision in the coming weeks or months on whether the deal will reduce competition too much in the Canadian market. Royal Bank already received the green light from the Competition Bureau, but the government’s finance committee recently recommended that the finance minister block the acquisition.
If the deal goes through, Royal Bank should get a nice earnings boost, and investors could see a solid dividend increase next year. In the event the government blocks the acquisition, Royal Bank will find itself in a similar situation to TD with significant excess cash that can be used to navigate an economic downturn or be deployed on other takeover opportunities, potentially in the United States or Europe.
Royal Bank trades near $116 per share at the time of writing compared to about $140 in February. The stock currently trades for about 11.2 times trailing 12-month earnings and provides a 4.7% dividend yield.
Is one a better pick?
TD and Royal Bank both look oversold today and should be solid picks for a portfolio focused on passive income. TD is a bit cheaper and offers a slightly higher yield. Royal Bank’s share price could move meaningfully on either positive or negative news on the HSBC Canada deal. With that thought in mind, I would probably make TD the first choice today or at least split a new investment between the two stocks and look to add to the RY position if the share price pulls back on the government’s deal decision.
