The rally that has occurred in Canadian bank stocks over the past two months caught many investors by surprise. Those who missed the bounce are wondering which TSX bank stock might still be undervalued and good to buy for a self-directed Tax-Free Savings Account (TFSA) or Registered Retirement Savings Plan (RRSP) portfolio for next year.
Interest rate impact
Movements of the share prices of Canada’s large banks over the past two years have largely mirrored the action in the bond market that has been driven by interest rate changes, or the expectation of moves, by the Bank of Canada and the United States Federal Reserve.
The central banks raised rates aggressively to cool off the economy as a means of lowering inflation. At its peak, inflation topped 8% in Canada and 9% south of the border. The November reports came in at about 3%, so progress has been made, and inflation is approaching the 2% target.
Investors feared, however, that the central banks might have been too aggressive. Rate hikes take time to filter through the economy, and there is a risk that rates will have gone too high and will remain elevated for too long. In the worst-case scenario, the economy would plunge into a deep recession and cause a sharp spike in unemployment. This would be bad news for the banks that are already seeing businesses and households struggling to cover higher loan expenses along with the rise in the cost of living.
Why did bank stocks rally?
Sentiment is a powerful force in the markets. In early November, markets started to price in rate cuts in 2024. This led to a sharp rally in bonds over the past two months that drove down bond yields, which in turn has reduced rates the banks charge on new loans. At the same time, economists are increasingly feeling comfortable with predicting a soft landing for the Canadian and American economies as inflation subsides and the central banks begin to reduce interest rates. A short and mild recession, or no recession at all, would be positive for businesses. As long as people keep their jobs and interest rates are falling, the banks should avoid a large wave of defaults. In fact, some might even be able to reverse provisions for credit losses that they made in fiscal 2023.
Risks
Interest rates remain high. While bond yields are down more than 1% from the 2023 peak, households and businesses that have to renew fixed-rate mortgages are still getting a shock. Inflation in Canada was 3.1% in November. That’s unchanged from October. If inflation remains sticky through the first half of 2024 or increases due to new shocks to the global economy, the Bank of Canada could be forced to keep rates at the current level through the end of next year. If the market starts to sense that it got ahead of itself, bonds could sell off again, and bank stocks would likely give up some of their recent gains.
Royal Bank is currently up 4.5% for 2023 and now trades at 12.75 times trailing 12-month earnings. That’s not cheap.
Bank of Montreal rose 27% in the past two months. TD is up about 12%, and Bank of Nova Scotia has bounced 15%.
Should you buy the banks now?
The large Canadian banks deserve to be part of a buy-and-hold portfolio. Over the long haul, they tend to deliver attractive total returns. Additional upside is certainly possible in the coming months, but investors should take a cautious approach. Any change in market sentiment on the expected timing of rate cuts could trigger a sharp reversal. Investors who are of the opinion that rates won’t get cut next year should probably look for other opportunities.
Otherwise, if you want to start nibbling, I would probably take a contrarian approach and make Bank of Nova Scotia and TD the first picks right now. BNS offers a 6.6% dividend yield today, so you get paid well to ride out the turbulence. TD trades near $85, which is still way off the $107 it reached in early 2022, so there should be decent long-term upside potential.
