Banks had a lot to say about the economy this week: It's complicated - The Globe and Mail

Though bank executives had lots to say about the economy during earnings calls with analysts, there was no definitive take.Andrew Vaughan/The Canadian Press

After Canadian banks finished reporting their latest quarterly financial results this week, investors hoping for some clarity on the economy may have come away disappointed. No clarity here, which could limit the recovery in bank stocks.

The banking sector is meandering between two very different outlooks: mild optimism that a recession will be brief or avoided altogether, while lending activity holds up and borrowers pay off their loans; and simmering pessimism that rising interest rates will wallop economic activity, pushing bank loan losses sharply higher.

Reflecting the optimistic take, bank stocks have risen by an encouraging 8 per cent this year, on average. Then again, pessimists will point out that these stocks are down more than 14 per cent since the start of 2022.

Though bank executives had lots to say about the economy during earnings calls with analysts, offering valuable insights given the banks’ unique perspective on lending activities and consumer indebtedness, there was no definitive take.

Dave McKay, Royal Bank of Canada’s RY-T chief executive officer, said during an earnings call that the bank is forecasting a “softer landing, characterized by a modest recession” – which sounds like a good reason to buy bank stocks right now.

But Mr. McKay also said that banks were operating within a “complex and fluctuating macro and market environment,” characterized by stubbornly high inflation, labour shortages, geopolitical shocks and the lagging impact of central bank interest rate hikes.

Ugh. And if actions speak louder than words, then the banking sector’s reaction to rising borrowing costs and slowing economic activity merely added to the murky backdrop for investors.

The banks set aside more money in their fiscal first quarter to handle the prospect of defaults: The Big Six banks collectively reported nearly $2.5-billion in provisions for credit losses – or PCLs in banking jargon – up from a net $373-million in provisions in the same period a year ago, when some banks were booking recoveries from previous provisions.

The spike in provisions supports the bearish case against bank stocks, but there was an upbeat context here: Provisions were actually lower than what most analysts had been expecting, and executives framed the increase as a step toward historically normal losses after a period of unusually low losses a year ago.

“This is indicating that credit is deteriorating and we’re still not at historical averages. But the question becomes: Will PCLs just stop there or will they overshoot?” John Aiken, an analyst at Barclays, said in an interview.

“This is where both the bulls and the bears can look at the PCLs this quarter, and it can bolster their case,” Mr. Aiken added.

It’s little wonder, then, that bank stocks are also sending conflicting signals about whether this economically sensitive sector is in the midst of a further recovery or poised for another downturn.

Bank-stock valuations are slightly below the historical average, based on estimated price-to-earnings ratios. According to Gabriel Dechaine, an analyst at National Bank Financial, the discount was 8 per cent as of market close on Thursday.

But this discount is considerably narrower than it was at the start of the year, before stock prices rebounded. Valuations are no longer particularly cheap in the face of economic risks – suggesting that the collective wisdom of the market can’t figure out whether the sector should be avoided on fears that the economy is in trouble, or scooped up on hopes that central banks have beaten inflation.

Specific stocks within the sector reflect similar bafflement.

CIBC CM-T is leading the way among the Big Six bank stocks in 2023, with gains of nearly 15 per cent. The bank has a relatively large exposure to the domestic mortgage market, making the stock sensitive to economic data. The stock’s outsized gains this year suggest some investors are betting on a healthy economy.

But wait a minute: Over the past year, CIBC is near the bottom of the pack with a decline of more than 21 per cent. Compare that with RBC – a bigger and more diversified bank, making it a safer bet during economic uncertainty: The stock is down less than 2 per cent over the past year. RBC’s outperformance suggests that investors are still nervous.

The one thing that just about everyone can agree on? If the banking sector’s financial results were supposed to give investors a clearer view of the year ahead, they failed to deliver.

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Banks had a lot to say about the economy this week: It's complicated - The Globe and Mail
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