Paul Bagnell

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It was the quarter the skeptics have been waiting for.

A moderating Canadian economy, strict new stress-test rules on mortgages and a stomach-churning market selloff in late 2018 all contributed to the weakest quarter of Canadian bank results in recent memory. Only one of the major lenders, Bank of Montreal, reported earnings that exceeded analysts’ estimates. Loan losses rose, capital markets profit collapsed, and Canadian retail banking growth was non-existent to modest.

The biggest weakness was in the banks’ capital markets segments, where the punishing market declines of November and December (the first two months of the banks’ fiscal 2019) came home to roost on income statements. 

Traders like volatility, but it’s hard to find opportunities for profitable trading when all the volatility is to the downside. And few publicly traded companies are interested in issuing new shares or new debt into that type of market. And they tend not to reach out to investment bankers for advice on mergers and acquisitions when markets are weak. All of those services are delivered in the banks’ capital markets or “wholesale” units.

It was Toronto-Dominion Bank that was most affected. TD actually turned in a stunning capital markets loss in the quarter, and that weakness was enough to prompt the bank to issue a profit warning later that day.

On the TD conference call, analysts peppered management with questions about how things could have turned out so poorly. (TD’s spending on building up its capital markets business outside of Canada may have been a big contributor to the loss. While revenue fell 35 per cent, expenses soared by 14 per cent).

I asked two experts how concerned shareholders should be about weakness in capital markets hampering profit growth for the remainder of fiscal 2019.

“I think we’ve seen the bottom,” said Greg Newman, my guest co-host on The Street the morning after TD and Canadian Imperial Bank of Commerce closed out the first-quarter earnings season. Newman is a director and portfolio manager at Scotia Wealth Management.

“We knew this was going to come. We saw it with the U.S. banks that reported a month earlier. Credit froze up, and it really hit them in capital markets. This year, so far, has been the antithesis of that.”

Newman noted that the banks – even TD, after scaling back its outlook – are still looking for higher profits in 2019.

Robert Colangelo, senior vice-president at DBRS in Toronto, told me he and his colleagues at DBRS actually expected more weakness in capital market than the banks eventually reported. He too pointed to the glaringly weak performance of the U.S. banks in the fourth quarter of 2018.

“Markets were challenging and that put many clients on the sidelines,” he said, of the reduced trading activity the banks experienced. “These businesses are client-driven.”

“And there was a reduction in corporate activity - fewer equity and debt issuances, and less M&A activity.”

One promising sign, Colangelo noted, is that bank executives said the investment banking pipeline was strong by the end of the quarter, meaning deal flows could pick up later in 2019.

Another theme was modest growth in the banks’ biggest segment – Canadian retail banking. Three banks reported flat or lower profit in Canadian banking: Bank of Nova Scotia (flat), BMO (flat) and CIBC (down 4 per cent).

“There was sluggishness,” said Colangelo. “Mortgage growth slowed. This is why the banks have diversified outside of Canada.”

It’s worth noting that two banks did manage to report solid growth in Canadian banking. TD posted six per cent profit growth and eight per cent revenue growth in Canada. And National Bank of Canada, which is active mainly in Quebec, came in with seven per cent profit growth in domestic banking.

But Colangelo’s point about non-Canadian diversification is a good one. All of the Big Five banks now have meaningful banking platforms outside of Canada. CIBC was the latest to bulk up, when it bought PrivateBancorp of Chicago in the summer of 2017.

Four of the five non-Canadian banking businesses delivered double-digit profit growth in the U.S. (TD, CIBC and BMO) or in other non-Canadian markets (Scotia).

Dividend increases were another counterbalance to a dismal quarter. Royal, TD, Scotia and CIBC all announced hikes to their dividends. And the two that did not, BMO and National, raised their dividends three months ago.

Even with the share price gains we have seen since late December, the bank stocks now have dividend yields ranging from four to five per cent.

That’s an attractive yield, Newman notes, compared what else is available out there – like 10-year Canadian government bonds (now yielding 1.9 per cent), or a bank-issued GIC (now yielding between 2.45 and three per cent). And Canadian dividends, of course, receive preferential tax treatment via the dividend tax credit.

Says Newman: “I think there is a real appetite to invest in something like that.”