Bank of Nova Scotia (TSX:BNS) has underperformed the other large Canadian banks in recent years. The steep pullback in the share price has contrarian investors wondering if BNS stock is now undervalued and good to buy for a self-directed Tax-Free Savings Account (TFSA) or Registered Retirement Savings Plan (RRSP) portfolio.
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Impact of interest rates on bank stocks
Bank stocks have taken a beating this year as investors worry that the Bank of Canada’s rate hikes have been too aggressive. The central bank is trying to get inflation back to its 2% target by cooling off the economy. Raising interest rates is viewed as the best way to achieve the goal as it forces businesses and households to spend less on discretionary items as they allocate more cash to cover debt expenses.
The ideal situation is one where the Bank of Canada gets inflation under control without causing a major recession. Based on the plunge in the share prices of bank stocks from the 2022 highs, the market seems to think a hard landing is on the way.
According to economists, rate hikes take 12-18 months to fully work their way through the economy. There is a risk that the central bank has already pushed rates too high and will keep them elevated too long. If a deep economic slump occurs and unemployment spikes while people are still struggling with higher loan expenses and elevated living costs, there could be a wave of loan defaults and bankruptcies. This would potentially put the banks in a bad situation.
Bank of Nova Scotia nearly doubled its provision for credit losses in the fiscal third quarter (Q3) of 2023 to more than $800 million compared to the same quarter last year, so the bank is already seeing some stress among clients. While that sounds like a lot, it is still very small relative to the overall loan book.
Economists are largely of the opinion that the Bank of Canada will be able to get inflation under control without causing a major recession. Assuming they are correct, Bank of Nova Scotia is probably oversold right now.
Bank of Nova Scotia stock
The stock trades for close to $59 at the time of writing compared to $93 at the peak in 2022.
Investors who buy BNS stock at the current price can get a 7.2% dividend yield. The board increased the dividend earlier this year, so the management team can’t be too concerned about the profit outlook.
Bank of Nova Scotia finished fiscal Q3 2023 with a common equity tier-one ratio of 12.7%. That’s well above the 11.5% required by the government and is an ample capital cushion to ride out some challenging times.
Is BNS stock now a buy?
Ongoing volatility in the bank sector should be expected until there is clarity on the economic impact of the Bank of Canada’s battle to get inflation under control. That being said, Bank of Nova Scotia has an attractive dividend that should continue to grow, and investors get paid well to ride out any additional turbulence.
As soon as the central bank signals it will begin to lower interest rates, bank stocks could soar. If you have some cash to put to work and are a contrarian investor, this might be a good time to start nibbling on BNS stock.
