Investors betting Canadian banks will continue to book robust profits

Investors are setting a high bar for Canadian bank profits after share prices soared this year, and analysts expect lenders to meet those expectations bolstered by strong capital markets activity and rising loan demand.

Canadian bank stocks have surged 24 per cent this year in the lead-up to posting third-quarter results next week as the lenders withstood mounting concerns over trade uncertainty and geopolitical tensions.

The group is outperforming the S&P/TSX Composite Index’s 14.6-per-cent climb and the 13.6-per-cent jump of the KBW Bank Index, which tracks U.S. lenders. Analysts estimate earnings-per-share could increase about 15 per cent year-over-year and are cautiously optimistic that the Canadian banks will meet the lofty expectations of shareholders.

“We expect results to once again feature upside surprise potential on consensus EPS estimates, largely on the back of strength in the capital markets business, while stable to modestly higher [net interest margins] and improvement in commercial lending volumes, particularly on U.S. exposure, should also be constructive,” Bank of Nova Scotia analyst Mike Rizvanovic said in a note to clients.

“Current elevated valuations remain a concern for investors heading into the quarter, suggesting a very high bar on results to get share prices moving meaningfully.”

The banks have been focused on building their return on equity – an industry metric that measures profitability – while playing down the potential for larger takeovers to drive growth. With rich valuations in share prices, some analysts are watching for renewed interest in acquisitions.

“The M&A question looms,” National Bank of Canada analyst Gabriel Dechaine said. “With their stocks setting all-time highs, and with relative valuation versus U.S. banks stretching beyond historical averages, the M&A question will undoubtedly surface during earnings calls. However, given the emphasis on ROE expansion as a strategic pillar, the M&A answer isn’t clear-cut.”

Financials’ share of Toronto index hits eight-year high as bank valuations surge

On Tuesday, Scotiabank BNS-T and Bank of Montreal BMO-T will report earnings for the three months ended July 30. National Bank NA-T will post results on Wednesday. Royal Bank of Canada RY-T, Toronto-Dominion Bank TD-T and Canadian Imperial Bank of Commerce CM-T will wrap up the week with earnings releases on Thursday.

While the threat of an economic downturn initially prompted concerns over whether banks could continue to churn out higher profits, analysts say Ottawa’s attempts to diversify trade relationships and introduce new business-related initiatives have helped prop up growth.

“Beyond trade negotiations, PM Carney appears to have revived investor sentiment toward Canada through a business-friendly policy agenda,” Bank of America analyst Ebrahim H. Poonawala said.

“The upcoming investor event, first of its kind, where the PM is inviting 100+ of the world’s largest investors to a summit in Toronto in mid-September, could further strengthen expectations for a multiyear investment cycle. Banks should be major beneficiaries,” he added, referring to the Canada Investment Summit scheduled for September in Toronto.

Volatile equity markets have boosted trading activity, propping up capital markets and wealth management units. Analysts believe that run is expected to continue on the back of some major deals in recent months.

In June, all six banks participated in Apotex Health Corp.’s $1.3-billion initial public offering – the largest life sciences and pharmaceutical IPO in Canadian history. RBC was the only Canadian bank on the list of 23 bookrunners involved in the SpaceX IPO.

“It is shaping up to be another strong quarter for corporate and investment banking revenues,” Raymond James analyst Stephen Boland said.

“Healthy financing conditions, elevated equity markets, and active client pipelines should continue to support mergers and acquisitions, equity capital markets, and debt capital markets activity across the group.”

While loan growth has slowed as consumers and businesses face the pressure of high borrowing costs and economic uncertainty, commercial lending has started to show signs of picking up even as demand for residential mortgages is expected to remain muted.

Data in May from the Canada’s banking regulator, the Office of the Superintendent of Financial Institutions, indicated that loan balances rose 1.1 per cent from the month prior. That implies that loan growth could climb to the mid- to higher-single digits, according to CIBC analyst Paul Holden.

Commercial lending is leading the rise, increasing 1.7 per cent from the prior month across the six biggest banks. Foreign-currency commercial balances increased 2.6 per cent month-over-month, well above domestic growth of 0.5 per cent, Mr. Holden said.

When U.S. banks posted second-quarter results in July, total loans grew about 2 per cent from the previous quarter, led by a 4-per-cent rise in commercial balances. Mr. Holden expects BMO, with its large U.S. commercial business, to benefit from this trend.

Even so, analysts remain skeptical that share price valuations will remain lofty as economic challenges persist.

“With a high degree of uncertainty still embedded in the banks’ outlook, the market continues to shrug off concerns and allocate record high multiples,” Jefferies analyst John Aiken said.

“While we do not believe that the third quarter will pull the rug out from under their valuations, we maintain our stance that earnings will need to grow into their current prices, which is far from a near term guarantee.”