A few weeks ago, I talked about the comparisons between Canadian equity dividend yields and the yields that bonds were now offering. Prior to that commentary we had already seen a meaningful rally in both bonds and stocks and that rebound continued, at least for bonds, into this week. One sector of the Canadian market that gets a lot of focus when it comes to the dividend discuss is banking, yet there has been some rumblings, even though the recent earnings reports were largely positive.

 

 

Prior to the last week of November, the TSX bank sub-group had enjoyed a nice bounce from its October lows (which was actually the worst point the group had seen since March 2021). From its record high reached in February of this year, bank shares fell more than 26% in October, but had rallied about 15% through most of November. This month we are down about 2%, but the drop was closer to 3% yesterday thanks to an announcement by the Office of the Superintendent of Financial Institutions (OSFI) that it was raising its capital requirements for banks.

 

As a reminder, Canada’s bank regulator sets minimum capital ratios for institutions in order to guard against increasing economic and financial vulnerabilities.  After the financial crisis, ratios here and abroad were boosted to protect against a similar development down the road. Back then, Canadian bank stocks were hit hard as US financial institutions fell, but we did not face anything close to what happened there either in housing performance or financial instability. Looking out the window today, everything looks ok, but there are some disturbing developments beginning to bubble to the surface.

 

This week, Equifax reported that consumer debt in Canada hit $2.36 trillion in the third quarter – an increase of 7.3% from the same period in 2021. Over the course of this year, we have fielded questions as to how are Canadians continuing to spend, even with government support programs basically gone and help wanted signs still being posted in shop windows? Some of this has come from higher wages for those employed, while the resilience in spending has also come from a draw down in personal savings that built up through the pandemic. There has also been an increased use of credit during this phase. According to Equifax, there was a 17.3% jump in credit card spending from the third quarter in 2021 and that amount is at a record. Part of this increase has stemmed from sub-prime borrowing and this is always a warning sign for the health of consumer balance sheets as it suggests traditional bank lending vehicles are unavailable.

 

 

At a macro level, we know that income is not keeping up with debt. As the above chart shows, the level of household and non-profit debt to disposable income rose to 182.6% in the second quarter of this year. This surpassed the previous record of 181.1% set back in 2018 and the pace of increase in this ratio has clearly accelerated. At the same time, we are beginning to see delinquencies tick higher and Equifax noted that there was also a slight increase in the number of consumer proposals by seniors.

 

This latest news on the country’s household debt situation was not the only factor going into OSFI’s decision this week, but you can see that Ottawa is taking this vulnerability more seriously. The DSB, or domestic stability buffer, that banks need to hold as Common Equity Tier 1 (CET1) capital will be raised to 3% in February, from the current 2.5%.  The DSB range was also increased from 0-2.5% to 0-4%.  With the new target, the CET1 capital ratio for banks goes to 11%. The good news is that Canada’s big-5 banks are already above this new target to the tune of about half a percent, or roughly $62 billion in excess. The problem is that some banks are in the middle of some hefty acquisitions south of the border that will require a significant chunk of capital – enough to eliminate this excess.  

 

BMO’s deal to acquire California-based Bank of the West and TD’s plan for First Horizon are both expected to close in the first half, while RBC’s recent announcement to acquire HSBC assets is set for late-2023.  The reaction by traders on Thursday was to be expected, even though Ottawa’s heighted sensitivity to the debt situation has been known for a long time. 

 

 

In terms of portfolio implications from the latest news, we were already underweighting banks coming into December given that the rebound from October was starting to look a little overdone and dividend yields were being compressed.  Fears of a 2023 recession and talk from both the Bank of Canada and the Federal Reserve that interest rates may still have to move higher are clearly not positive for consumers that are heavily in debt, nor the housing market. Based on the recent Bank of Canada hike of half a percent, the qualifying mortgage rate for homebuyers could come in at 8%.

 

Depending on general market sentiment, we could see banks reverse more of the post-October bounce and I would not rule out a re-test of the October lows. That said, the new capital targets are a positive for the sector longer-term and continue to set Canadian banks apart from their global peers as the best capitalized sector in the G7. Provided dividend growth rates remain as expected and we see room for continued share buybacks, we will definitely look at meaningful pullbacks as an opportunity.

 

The next Pyle Group conference call will take place on Wednesday December 14th at 7pm ET. As always, we will be taking participant questions live on the call but we will also answer any questions that are emailed to myself at andrew.pyle@cibc.com. Details for the call are below.

 

Participants:

Toll-free dial-in number (Canada/US): 1-800-806-5484

Local dial-in number: 416-340-2217

Participant passcode: 8696976#

International dial-in numbers: https://www.confsolutions.ca/ILT?oss=7M9R8663038430

 

On behalf of the Pyle Group, have a wonderful weekend.   

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.

 

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