Canadian investors have long held shares of the country’s largest banks in self-directed retirement portfolios focused on dividends and total returns. Volatility in the sector over the past few years has investors wondering if Canada’s banks are still good to buy and if any are now undervalued.
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Bank stock outlook
Canadian banks enjoyed a nice two-year rally after the initial pandemic crash. The rebound through the first part of 2022 occurred as investors realized that generous government support for businesses and households was driving up savings and helping avoid a surge in bankruptcies. Low interest rates during that timeframe also stoked a buying spree in the housing market as people headed for the suburbs and smaller communities in search of larger homes that provided space to work.
Sentiment shifted in early 2022 when it became evident that high inflation was going to force the government to aggressively raise interest rates. As rate hikes picked up speed in 2022 and 2023, bank investors feared the moves would trigger a recession and that borrowers who binged on too much cheap debt would start to default in large numbers. Bank stocks trended lower until the fall last year when a new rebound kicked into gear on expectations that rate hikes were done and that interest rates would begin to decline in 2024. This has been the case, and more rate cuts are expected by the Bank of Canada through 2025.
The positive side of lower interest rates should be reduced provisions for credit losses (PCL) as borrowers get a bit of a break. Lower interest rates, however, also tend to reduce net interest margins the banks earn on loans, so there are two forces at play.
As long as the economy holds up and unemployment doesn’t surge in the next two years, the drop in interest rates should be a net positive for the banks. Businesses can take advantage of the reduced borrowing costs to make investments to grow their operations. In theory, households should be able to renew mortgages at more favourable rates.
Risks
In recent weeks, the bond market has been moving in a different direction than what might have been expected on the heels of rate cuts by the Bank of Canada and the U.S. Federal Reserve. Bond prices have fallen, driving up yields. This typically results in higher borrowing costs for businesses and households. Fixed-rate mortgage rates in Canada normally follow moves in government bond yields. The Canadian Bond market generally moves in the same direction as U.S. treasuries.
The reason for the bond selloff could be that expectations are shifting on how aggressive the rate cuts will be in the coming months. In the United States, the economy and the jobs market remain robust, so rate cuts might get put on hold or at least could occur at a slower pace. In Canada, the story isn’t as clear, but the Bank of Canada can’t let the gap in rates between Canada and the U.S. get too wide.
Add in the uncertainty around this week’s U.S. election and the coming election in Canada, and you get conditions for some potential volatility. Donald Trump has said he intends to implement tariffs of 10% on goods entering the United States. In Canada, a majority win by the Conservatives could lead to big changes designed to make the banking sector more competitive.
The bottom line on Canadian bank stocks
Investors should expect some turbulence in the banking sector over the next couple of years. That being said, the large Canadian banks pay good dividends and tend to deliver solid total returns over the long run. If you have some cash to put to work, one option might be to take a half position now and look to add on weakness.
Contrarian investors seeking higher dividend yields might consider TD Bank, Bank of Montreal, or Bank of Nova Scotia. The stocks have underperformed Royal Bank, CIBC, and National Bank over the past year and could make up some ground in the next few years as they work through various challenges in their non-Canadian operations.
