In my opening remarks at this week’s conference call (playback details at the end of the commentary), I lamented how today’s opening of the Canadian National Exhibition marked for me the end of summer as a kid growing up in Toronto. As much as some won’t like the earlier sunsets, most will take solace in the fact that markets have recovered over the last month. As I discussed the other week, not all sectors and stocks have improved at the same pace, and this offers opportunities even if we think that the general market recovery might fade.

 

In the past couple of weeks, we have been removing exposure to Canadian consumer and utilities. At the same time, there have been opportunities in energy and materials as well as other dividend-payors like telcos.  Through the move from the second quarter into the summer, we have also been attracted to Canadian banks.  There has definitely been a recovery in this group as well since mid-July, however, it remains down close to 6% since the start of the year – pretty much in the middle of the pack in terms of the major sub-groups of the TSX. On a total return basis, the comparison is more in favour of banks.

 

If we assume dividends are reinvested in the bank group, the total return is close to minus 3%, which is not far from the total return for the overall TSX so far this year. There has been a fairly synchronous move higher among the big five banks, though BMO and RBC have definitely outperformed, with total year-to-date returns of roughly positive 2.5% for BMO and minus 0.7% for RBC. The rest of the pack are sitting with negative total returns of 5-6.5%.

 

In a rising rate environment, we typically think of banks as having the upper hand.  Margins tend to move higher as the gap between lending rates and deposit rates grows. The problem is that this works mainly in an environment where there is a positively sloped yield curve. In other words, when long-term bond yields are higher than short-term ones. The problem is that we are far removed from such an environment and the curve is now what we call inverted.

 

The spread between the 10yr Canadian government yield and the 2yr yield is now hovering near 50 basis points (0.5%). This is the most inverted the curve has been since 1990 and it has definitely fed into the bearish narrative. The reason is because inverted yield curves have been precursors to economic recession. Not all the time, but over the past three decades we have, in fact, seen Canada’s economy contract after the yield curve inverts. To think that the spread between the 10yr and 2yr yields was north of 120 basis points only last year highlights the magnitude of this shift.

 

To better understand why we spend so much time looking at the shape of the yield curve and how it corresponds to bank stocks, we have to step back and understand that most stocks, in particular banks, don’t do well in economic recessions. People get laid off, corporate profits decline and both camps may not pay their debt obligations. Delinquency rates go up and so do defaults. Home prices drop and borrowing costs move up so high that some have to leave the house keys in the mailbox. Etc, etc, etc. 

 

What if the inverted yield curve isn’t really forecasting this scenario but a situation that is equally as distorted as everything that has taken place since 2020. The curve is inverted because the short end of the curve is pricing in continued aggressive rate hikes by the Bank of Canada (and the Federal Reserve), whereas longer-term bond yields are actually down from their highs because investors are coalescing around the view that inflation is beginning to ebb, which will allow central banks to take a more moderate approach to monetary policy tightening, or maybe not tighten at all beyond next month’s meetings.

 

In that scenario, economic demand slows but does not get crunched as consumers and businesses adjust to a higher rate environment, but without the fear of further escalation. That would typically provide room for home prices to stabilize as well, reducing concerns of growing defaults. This environment would also be favourable to bank earnings and support dividend growth.

 

 

Investors will get a peek at how banks fared during the recent fiscal quarter (May to July), starting with BNS on the 23^rd. Our research team expects to see decent results on the lending side, however, given the state of capital markets in the quarter, trading revenues could see some moderation. In terms of valuations, three of the big five are trading at P/Es below 10 (BMO, CIBC and BNS), while RBC and TD are trading above 11. The recent recovery has brought stock prices closer to overbought levels, but we aren’t there yet, in my opinion. 

 

 

While there will probably be no dividend hikes announced in these upcoming results, dividend yields are for the most part above 4% (RBC is just a hair below this level). Both RBC and BMO have grown their dividends north of 20% since right before the pandemic, but the others have still seen decent growth. If we do see a fade in stocks, either due to Q3 results or general market conditions, but without indication of a significant deterioration in fundamentals, then this could be an opportunity to add exposure.

 

Pyle Group conference call playback details

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Have a great weekend everyone

Andrew Pyle

 

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These are the personal opinions of Andrew Pyle and the Pyle Group and may not necessarily reflect those of CIBC World Markets Inc.

Yields/rates are as of August 19, 2022 and are subject to availability and change without notification. Minimum investment amounts may apply.