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Higher interest rates have been seen as a positive for the banking sector. But will economic setbacks and market uncertainty weigh on profits going forward? Greg Bonnell speaks with James Hunter, Banks and Insurance Analyst at TD Asset Management, about the outlook for financials.
Transcript
Greg Bonnell: Rising interest rates can be viewed as a positive for the banking sector, but hasn’t played out that way through 2022. Joining us now with more, James Hunter, bank and insurance analyst at TD Asset Management. James, welcome to the program.
James Hunter: Thanks very much for having me, Greg.
Greg Bonnell: So let’s talk about the year that we’ve had. Obviously, we know that as central banks try to tame inflation and interest rates move higher, it’s had a lot of effects on a lot of different asset classes. At first blush, you would say, well, financials enjoy a higher rate environment. Is it more complicated than that?
James Hunter: It can’t be more complicated than that. But when you think about this year, that is mostly how it’s played out on a total return basis. The banks are down a few percentage points, the insurers are up a little bit. And so that they’re sort of very close to the TSX. And our thesis going into the year would have been that the banks and insurance companies will benefit from rising rates, banks because they have higher profit margins and the insurers because they’ll generate more investment income on their investment portfolios. So you’ve seen that in the earnings estimates. Those have risen. Dividends have been really good, 4 to 5% yield and there’s been some double-digit dividend increases, which is really great. And the thing that’s sort of held them back to your question is just valuations have come down a little on recession fears. So we’re working through that now. But overall, I’d say the financials have really been holding their own.
Greg Bonnell: As they hold their own, what are some of the challenges of a higher rate environment? I think in terms of maybe even just the loan book, we’re hearing so much about the Canadian housing market, that was slowed dramatically because borrowing costs are higher. Has that come to visit the banks at some point?
James Hunter: Yeah, if we talk about credit, you have to keep in mind that Canadian banks have about a $3 trillion loan portfolio. So it’s significant. And every year they have to put aside some of their profits for loans that could go bad. Those are the provisions for credit losses and those could go higher as we get closer and closer to this economic recession that we might go into.
The thing that’s really been helping them offset this has been higher margins. There’s been really good revenue growth. They benefit from the higher interest rates. There’s been pretty good expense control as well. So yeah, there is this give and take between provisions and the revenue and expense side of things that has been pretty strong this year.
Greg Bonnell: What do we need to think about for 2023? Right now, it seems that a lot of people are baking in a recession and the big debate becomes, is it a deep recession? Is a shallow recession? I think we were hearing just in a lunchtime chat from the senior deputy governor of the Bank of Canada saying, you know, they feel that the moves they made so far to raise borrowing costs are working. But you know, to avoid a hard landing, that’s what everyone wants, right? So a sort of soft landing. In that environment, do the banks end up having a favorable situation with, you know, nice interest margins, but not a ballooning of provisions to try to cover bad loans?
James Hunter: Yeah. So the nice situation is, is basically what played out this year where you had the revenue growth really be there to offset the increase in provisions which we’re starting to see that now. It showed up a little bit in Q3 and it will probably be something we’ll seeing in Q4 as well. So I think that’s the good part of the story happened this year. And next year, there are there are more risks around that part of the story where the revenue growth may not be enough to offset the increase in provisions. And so that’s what investors are really grappling with.
I think, you know, what we sort of think is that there is going to be a mild recession. And then the question about how deep or how shallow it is will influence sort of how positive or not positive you would be on the various stocks in the financial sector.
Greg Bonnell: What does it look like for insurance companies, LifeCos in this environment as well? I mean, that’s a great rundown on the banks and how their business performs and what it means with higher rates. What about some of those other names?
James Hunter: Okay. So the insurance sector, it’s actually quite interesting. You’ve got to keep in mind, there’s two different buckets to it. There’s the property and the casualty insurers, and then there’s the life insurers. The P&C Insurers have had a really good year. And the reason is because they’ve got inflationary pricing power. If you think about having an insurance policy for your home or your car, you don’t have you don’t have a choice. You have to have that. So if the insurer increases their rates by five or 10% or more because of inflation, you’re going to pay. And that’s resulted in higher earnings this year. And that’s been really good for those stocks.
The LifeCos, they haven’t been quite as good, but reasonably resilient given all the sort of difficulties we’ve had this year. Two things to keep in mind would be they have a lot of business in Asia. So for Manulife (MFC) and for Sun Life (SLF), the slowdown in insurance sales has been a bit of a headwind as there have been, you know, continued zero-Covid policies in that part of the world. And then the other part of it is an accounting transition. Not quite as exciting to talk about, but there’s going to be less earnings and there’s going to be less book value next year. And so the insurance companies are just having to let investors know that. And we’ve needed a little bit of time to digest that new information.
Greg Bonnell: When I think about the LifeCo side of it, obviously they have obligations that are long term, long term liabilities. And it felt like they had been in such a low rate environment for so long and we did see these banks move into other areas because they realized you weren’t going to get that kind of return in in the bond market. Are things changing now or at these levels? I mean, it’s been a dramatic rise in interest rates so far this year. But does it take the LifeCos anywhere back to where they used to be, how the business model used to be structured?
James Hunter: I would say that it helps. It takes time to filter through the earnings profile of the insurers. As you mentioned that the liability profile is quite long and that means that their assets are also pretty long in duration. And so every year that goes on where rates are a little bit higher or even hold at these levels, there will be more investment income flowing through the earnings profile of the LifeCos. It just it doesn’t happen in a quarter or two like it can with the banks. It takes a couple of years. So I think this will be a theme that will probably help them for the next couple of years if rates sort of stay at higher levels for a longer period of time.
Greg Bonnell: We’ve touched on the weakness of the housing market a little bit. And of course, we know that credit runs in cycles as well. What do we need to think about in terms of credit quality heading into 2023?
James Hunter: What we need to think about in terms of credit quality is sort of three things we need to think about, the unemployment rate and housing prices and commodity prices, those are the three sort of big factors that would go into the economic forecasts that really drive provisions and credit. And, you know, if you think about the unemployment rate, it’s been rock solid so far. It’s hovering in the in sort of the 5% range in Canada, which is low. And that’s really good for credit. It means that people have their jobs, they can pay their bills. So that’s a supportive factor.
The thing that is starting to sort of weigh on the outlook is that decline in housing prices. As that happens, people they don’t have quite as much confidence. And it’s happening because their mortgage rates are going up. So that sort of makes their budget a little tighter. And those factors can work in different directions at times. But over the next year or two, it’ll probably be a sort of a slowing direction rather than a more positive direction.
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