Royal Bank (TSX:RY) is up more than 20% since late October. Investors who missed the strong year-end rally in the TSX bank sector are wondering if RY stock is still undervalued and good to buy for a self-directed Tax-Free Savings Account (TFSA) or Registered Retirement Savings Plan (RRSP) portfolio.
Bank stocks outlook
Bank stocks peaked in early 2022 after the strong recovery from the 2020 crash. The decline that followed carried through right up to the end of October 2023. Investors who track what is going on in bond markets can see that the bank stocks slid as bond yields rose, driven by aggressive rate hikes by the Bank of Canada and the United States Federal Reserve, or more precisely, the market’s expectation for additional rate increases.
Up until the end of the third quarter (Q3) of 2023, investors were pricing in expectations for interest rates to continue to rise, as the central banks battle to get sticky inflation back down to the 2% target. Banks have been forced to increase their provisions for credit losses over the past year. Customers with too much debt are running into trouble when they have to renew fixed-rate mortgages at much higher rates. Borrowers with variable-rate loans take it on the chin immediately after each increase in interest rates.
At this point, the loan-loss provisions remain very low relative to the overall loan books, but markets were concerned that the central banks would have to force the economy into a steep downturn to get inflation under control. A plunge in spending could trigger losses in businesses and lead to a surge in unemployment. This would potentially create a wave of loan defaults and bankruptcies.
Surprisingly, sentiment has shifted dramatically in the past two months. Markets now expect the central banks to start cutting interest rates before the end of 2024 in order to orchestrate a soft landing for the economy. The most optimistic analysts predict a return of inflation back to 2% without the economy going through a recession. Economists broadly expect a short and mild recession to occur, followed by an economic rebound. In this scenario, bank stocks looked heavily oversold. That’s why the sector rallied so much in recent weeks.
Royal Bank stock
Royal Bank trades near $134 at the time of writing. That’s up from $108 at the 2023 low and not far off the $147 peak in early 2022.
Royal Bank raised the dividend twice in 2022, despite the headwinds, supported by a solid overall performance. The bank generated fiscal 2023 adjusted net income of $16.1 billion, up slightly from fiscal 2022. Adjusted return on equity slipped a bit but remained robust at 15.4%.
At the time of writing, RY stock provides a dividend yield of 4.1%.
Should you buy RY stock now or wait?
Royal Bank offers an attractive dividend that should continue to grow. If you already own the stock, it makes sense to continue to hold the position. Investors seeking a new anchor stock for a buy-and-hold portfolio targeting total returns should be comfortable buying RY stock today. However, I would keep the position small and look to add more on a pullback.
Inflation could turn out to be stickier than expected, and the central banks might need to keep interest rates at current levels until 2025. Bond yields are already starting to move higher again, which suggests the market is feeling less certain that rate cuts are coming soon. Another sentiment swing could push bank stocks lower and deliver a better buying point in the coming months.
