Weak growth a drag on bank profits

Economic growth in Canada for 2016 is expected to be sluggish, weighed down by low oil prices. The low Canadian dollar relative to the U.S. dollar could help manufacturing in Central Canada, but says Taylor: “We just don’t think it’s enough” to offset the effect of low commodity prices.

“[Oil prices] should be higher in the intermediate term, because we think the price is below the marginal cost of production,” says Stuart Kedwell, senior vice president and senior portfolio manager, Canadian equities, with RBC Global Asset Management Inc. in Toronto. “But the timing of that [up]turn is difficult to forecast.”

Low interest rates also continue to dampen the performance of Canadian financials, particularly for the banks, which must eke out earnings from narrow net interest margins. And interest rates in Canada are likely to remain steady in 2016, or even dip lower. “Lower for longer seems to be what’s in the cards,” says Jennifer Radman, vice president and portfolio manager with Caldwell Investment Management Ltd. in Toronto.

Low rates, in turn, will act as a drag on the loonie, particularly if the U.S. Federal Reserve Board raises interest rates in 2016.

In general, banks are underweighted, insurers are moderately overweighted and other financial services are underweighted. Here’s a look at the sectors in more detail:

– Banks. The Canadian banks are expected to generate earnings growth in the mid-single digits by controlling expenses and looking to foreign operations for growth. “If the banks can grow earnings by 5%-7%, I think they would actually be quite happy about that,” says Richard Nield, portfolio manager with Invesco Canada Ltd. in Austin, Tex.

One risk is loan losses, especially if low oil prices lead to a recession in Western Canada. “You don’t know what the severity of that [scenario] is going to be,” Radman says. “That’s the big wild card – the exposure not to just direct loans, but the whole economy, and to the West that is more tied to energy.”

Another risk is a correction in housing, but this risk is small. “House prices are elevated,” Kedwell says. “But any type of activity that sees them dampening is not likely to be extreme.”

Banks will continue to emphasize cost control, both because revenue will be harder to generate and because banks need to reinvest in their businesses on the technology and innovation fronts.

“There are new entrants in the marketplace – financial technology firms – and consumers themselves are changing the way they want to deal with their financial services provider [in terms of technology],” says Andre De Haan, leader of the financial services team at Ernst & Young LLP in Toronto.

The big Canadian banks raised dividends in 2015, and further increases are anticipated. “I think you’ll see some dividend increases, but the rate of growth is likely to be pretty modest – in line with earnings,” Taylor says.

The banks are likely to try to differentiate themselves in their non-domestic businesses. In general, Toronto-Dominion Bank and Bank of Montreal are favoured because of their large U.S. retail platforms. Royal Bank of Canada, which closed a deal for Los Angeles-based City National Bank in 2015, also is in this group. “The advantage is to the banks that have U.S. exposure,” Taylor says.

Bank of Nova Scotia is considered a good longer-term play, says Kedwell: “The ability to grow in its four primary foreign markets – Mexico, Colombia, Peru, and Chile – from the longer-term standpoint looks interesting.”

Meanwhile, Canadian Imperial Bank of Canada’s ambitious strategy of investing in technology and digital transformation also is attracting interest, but, again, over the long term. “The results will be [seen] closer to 2017 or 2018,” Radman says.

– Life insurers. Canada’s life and health insurers continue to be better positioned for growth than the banks, based on the insurers’ foreign businesses and investment portfolios. Insurers are expected to post earnings increases in the high single digits.

“[The insurers] have more non-domestic opportunities, more wealth management, more asset management [than the banks],” Kedwell says. “All three of these things are likely to power growth over the intermediate term a little bit higher than what’s available to the banks.”

Although long-term interest rates are not expected to rise significantly, rates will not be the headwind for the insurers that they might have been in the past. “A lot of the direct mark-to-market exposure has been hedged, so we don’t see wild [earnings] swings quarter to quarter,” Nield says.

Capital levels at the lifecos are strong, and dividends are expected to increase in line with earnings. The major risk for insurers remains a significant correction in global equities markets. “That would hurt the insurers more than the banks,” Nield says.

Among the lifecos, Manulife Financial Corp. and Sun Life Financial Inc., both of which expanded their businesses last year in Asia via partnership deals or acquisitions, are favoured.

– Property and casualty insurers. In general, this sector is underweighted. Kedwell, for one, likes Intact Financial Corp. “It’s a very high-quality company,” he says. “Unfortunately, its valuation is also reflective of its quality.”

Fairfax Financial Holdings Ltd. is favoured for both its core business and its investment portfolio, which is hedged against the market. “[Fairfax] is quite defensive. We like the characteristics it provides our portfolio,” Kedwell says.

– Asset managers. In general, this sector continues to be given a pass, due to concerns about downward pressures on the fees these companies can charge. “They’re competing against the banks, which have broader distribution and lower costs,” Taylor says.

An exception is Brookfield Asset Management Inc. because it’s a globally diversified firm with a solid track record of acquiring and disposing assets at the right time.

– Distributors. In general, portfolio holdings in brokerages, including Canaccord Genuity Corp. and GMP Capital Inc., are being avoided.

“There’s considerable uncertainty in terms of the institutional capital markets business, which they’re both exposed to,” Kedwell says.

The firms’ exposure to commodities also remains a concern. “On price-to-book valuation, they look very attractive,” Nield says. “But they’re heavily skewed toward resources, and that’s too speculative for our liking.”

Power Financial Corp. is favoured by Nield: “On an historical basis, it’s trading at a wider than normal discount to net asset value.”IE

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