We are joined this week by contributing editor Tom Slee who is our resident expert on the banks. With third-quarter results now out, he looks at the implications for investors going forward. Tom managed millions of dollars in pension money during his career and is an expert in taxation. Here is his report.
Tom Slee writes:
As a rule, interest rates surge late in the economic cycle. That's good news for banks. More expensive money normally reflects buoyant markets, brisk business activity, and increasing loan demand.
The trouble is, these are not normal times. The current jump in rates is not powered by a strong recovery. It results from bond market distortions caused by the U.S. Federal Reserve Board. If anything, the move handicaps banks as mortgage activity slows. We have the odd situation where bank executives are trying to reassure investors. Even more important, tighter money could actually snuff out a still fragile recovery. It's the last thing we need.
To put it bluntly, higher interest rates without meaningful economic growth and rising consumer confidence are likely to undermine rather than drive bank earnings. There are several reasons for this.
First and foremost, because this current rate adjustment is artificial it's badly skewed. Central banks are keeping a firm lid on short-term rates for the foreseeable future while yields in the long end are allowed to rise. This hurts the banks in two ways. They earn a great deal of their interest income from loans, such as commercial lines of credit and home equity debt, pegged to Prime. These margins will remain thin. At the same time, a lot of mortgage borrowers are going to defer commitments as long rates move up, especially now that they have become accustomed to record low-cost financing.
Another problem is that because of slack loan demand many banks have been awash in cash and buying bonds, so much so that we have an aberration in the system. According to the U.S. Federal Deposit Insurance Corporation (FDIC), securities made up 21% of lenders' assets as at the end of March. A great many of these holdings have plummeted in value and billions of dollars in unrealized losses are going to be reflected in the various capital calculations.
Bruce Thompson, Bank of America's chief financial officer, thinks that the Bank will need three years of net interest income to replace lost capital.
There is also the fact that banks have gradually become substantial bond traders for their own account and been able to generate significant profits. We have been accustomed to seeing these earnings. Now, heading into a fixed-income bear market, bond trading is bound to become less profitable. There may even be net losses. As you can see, there are lots of uncertainties.
U.S. bankers worried
CEO Jamie Dimon of JPMorgan Chase told a Fortune Global Forum: "The return to more normal interest rates is going to be scary and kind of volatile". It's not the sort of forecast you expect from a leading banker. We have been warned.
In fact, U.S. bank executives are concerned right now with new regulations as well as rising interest rates. They are strenuously complaining about expense controls, sound balance sheet rules, and credit loss provisions, the sort of standards we take for granted here in Canada. American bankers feel that all this red tape is hampering their operations but it's all long overdue as far as investors are concerned. In any event, the U.S. banking industry is showing signs of strength despite all the rules.
Industry top-line growth remains sluggish but banks have been gradually easing their lending standards and introducing higher fees in order to improve profit margins. Mortgage business has slackened recently as the refinancing boom fizzles although this is being partially offset by increased loan interest rate spreads. Wall Street analysts feel that U.S. banks, like their Canadian counterparts, are likely to struggle for a while but then grow more rapidly in 2014 and beyond.
Looking ahead, rising interest rates and increased loan demand should drive earnings as the recovery gains momentum. There are also other revenues coming on stream. Analysts expect to see more income from prepaid cards, higher minimum balances, and innovative credit cards. Cost-cutting continues and there have been more than half a million lay-offs during the last five years.
It all sounds promising but we have to keep one thing in mind. The American banking system is quite different to our tightly-knit, controlled Canadian banking industry. These are not defensive income stocks, although some of them fall into that category. There are bank failures, something that we rarely see in this country. During the second quarter of 2013 alone, 12 American federally insured banks failed. Last year there were 51 bank failures and that is just the tip of the iceberg. As of March 31, the FDIC had 612 U.S. banks on the "problem list".
I am not saying that American banking stocks are speculative, merely suggesting that you should tread carefully when assessing these companies. It's a sprawling, diverse industry with a lot of pitfalls. There are about 7,300 insured banks in the U.S. and hundreds of them are publicly traded. As a matter of fact, investment houses tend to group them in sections such as Banks - Southwest or Banks - Major Regional. It's easy to choose a stock that is really a special situation or heavily dependent on a unique regional economy.
My feeling at this stage in the cycle is that we should stay with a group of the largest banks that make up what is known as the Diversified Financial Services sub-industry. These institutions are extremely well capitalized and we should see them returning excess equity to shareholders in dividends and repurchase programs next spring when the Fed's stress tests are complete. In addition, their substantial international and investment earnings could pick up the slack if the American recovery falters. Equally important, these major players have continuing analyst coverage. We will be able to keep close tabs on the progress.
The outlook
My feeling is that banks are going to have a relatively rough passage over the next few quarters. I am not suggesting that they are going to incur operating losses. However, their crucial loan growth, the industry's lifeblood, is like to remain tepid until the underlying economy picks up steam. Everything depends on whether the recovery has traction.
The outlook is mixed. According to the Conference Board, U.S. GDP should grow 1.5% in real terms this year while here in Canada we are likely to see an increase of about 1.7%. Those are tepid numbers. In 2014, however, the Board looks for a more robust 2.8% growth in the U.S. and 2.5% in this country. Not everybody agrees. TD Bank CEO Ed Clark thinks that "2014 is going to be a tough revenue year".
Some of the difficulties are already apparent in the Canadian banks' third-quarter earnings. Our media greeted these as an earnings bonanza but when you scratch the surface there is not much to cheer about. Many analysts had downgraded their forecasts, especially in the case of TD Bank, so the bar was low. It looks as though total industry cash operating income was up a modest 4% year-over-year. The numbers were good enough to support some modest dividend increases but these came with disappointing guidance.
You'll find updates on my bank recommendations elsewhere in this issue.
Bank of Nova Scotia (TSX: BNS) (NYSE: BNS)
Originally recommended on Jan. 17/11 (#21102) at C$56.83, US$57.34. Closed Friday at C$60.03, US$57.67.
Scotiabank turned in a solid performance despite some difficult international markets. Cash operating earnings, excluding unusual items of $1.32, were up 15% from $1.15 a year ago and slightly ahead of the $1.30 consensus forecast. A 3.3% dividend increase to $2.48 annually was in line with expectations. Canadian banking earnings jumped an impressive 14% year-over-year but a lot of that was due to the ING acquisition.
One of the main reasons we have BNS on our Buy List is the bank's overseas exposure. This time, though, the International Banking segment produced lacklustre numbers. Good loan growth was offset by higher loss provisions and increased expenses. I should point out that about 40% of this business is in Mexico and the Caribbean, areas that reflect the spluttering U.S. economy. This is a case of battling headwinds until the recovery has real traction.
Nevertheless Scotiabank remains my first choice amongst the Canadian banks because of the balanced growth opportunities abroad and improving numbers from the ING business here at home.
Action now: Scotiabank remains a Buy with a target of $65. I will revisit the stock if it dips to $53.
National Bank (TSX:NA, Financial)
Originally recommended on April 11/11 (#21114) at C$76.69, US$80.22. Closed Friday at C$82.91, US$79.74.
National Bank reported third-quarter earnings of $2.22 per share, a 12% improvement over $1.98 a year ago and well ahead of the $2.06 consensus forecast.
The story here was a $186 million trading profit while Wealth Management income of $58 million was up 26% year-over-year. Most encouraging, there was an 8% growth in personal and commercial loans. Another plus is that National has acquired TD's Institutional Services Unit, a move that should add as much as $0.12 a share to the bottom line next year.
A year ago we put National on Hold at $77 because of possible reaction to the Quebec election. That proved to be a good move and the stock subsequently dropped into the $72 range. Now, however, investors are more receptive to NA.
Action now: National Bank is reinstated as a Buy with a target of $90. I will revisit the bank if it drops to $75.
TD Bank (TSX:TD) (TD, Financial)
Originally recommended on Feb. 12/07 (#2706) at C$69.85, US$59.59. Closed Friday at C$92.16, US$87.55.
TD Bank earned a $1.60 a share in its third quarter versus an expected $1.53 but down substantially from $1.78 the year before. The numbers were a mixed bag. TD's insurance and wealth division essentially broke even compared to a $360 million profit in 2012 because of flood losses and poor auto experience. Wholesale banking earnings were $147 million, well below the $200 million analysts were expecting. On the plus side, personal and commercial banking in Canada as well as the U.S. turned in strong earnings and the bank announced a 5% dividend increase to $3.40 per share annually.
The insurance loss was a shock and a reminder of why for many years banks were expressly forbidden from offering insurance. With natural disasters occurring more frequently, investors are bound to factor this exposure into the stock price going forward. For now TD is back on track and expected to earn about $7.75 a share in 2013 and $8.50 or so next year.
Action now: TD Bank remains a Buy with a target of $100. I have set an $80 revisit level.
JPMorgan Chase & Co. (JPM, Financial)
Originally recommended on Feb. 3/13 (#21305) at $47.85. Closed Friday at $52.56. (All figures in U.S. dollars.)
Looking south, the U.S. bank that I particularly like right now is JPMorgan Chase, an industry leader with assets of nearly $2.4 trillion and operations in more than 50 countries. It functions with four business segments, Consumer Banking, Corporate Banking, Commercial Banking, and Asset Management. Annual revenues exceed $106 billion and last year JPM reported net income of $21.3 billion.
In June, the bank announced a second-quarter profit of $6.1 billion or $1.60 per share, up 32% year-over-year and a lot better than the $1.44 consensus forecast. Investment earnings of $2.8 billion surged 19% from the second quarter of 2012, driven by increased underwritings as U.S. financial markets revived. Mortgage applications jumped 37% to $67 billion. It was an excellent performance and JPM is now set to make about $5.90 a share in 2013 with an increase to $6.25 next year.
There is one cloud on the horizon. JPM has been receiving a lot of bad press recently and that is likely to continue for a while. The Justice Department is probing the bank's trading practices and there are lawsuits pending.
However, it's worthwhile keeping in mind Chase's strong balance sheet and enormous income when any settlements are announced.
Action now: JPMorgan Chase remains a Buy with a $65 target. I have set a $42 revisit level.
Tom Slee writes:
As a rule, interest rates surge late in the economic cycle. That's good news for banks. More expensive money normally reflects buoyant markets, brisk business activity, and increasing loan demand.
The trouble is, these are not normal times. The current jump in rates is not powered by a strong recovery. It results from bond market distortions caused by the U.S. Federal Reserve Board. If anything, the move handicaps banks as mortgage activity slows. We have the odd situation where bank executives are trying to reassure investors. Even more important, tighter money could actually snuff out a still fragile recovery. It's the last thing we need.
To put it bluntly, higher interest rates without meaningful economic growth and rising consumer confidence are likely to undermine rather than drive bank earnings. There are several reasons for this.
First and foremost, because this current rate adjustment is artificial it's badly skewed. Central banks are keeping a firm lid on short-term rates for the foreseeable future while yields in the long end are allowed to rise. This hurts the banks in two ways. They earn a great deal of their interest income from loans, such as commercial lines of credit and home equity debt, pegged to Prime. These margins will remain thin. At the same time, a lot of mortgage borrowers are going to defer commitments as long rates move up, especially now that they have become accustomed to record low-cost financing.
Another problem is that because of slack loan demand many banks have been awash in cash and buying bonds, so much so that we have an aberration in the system. According to the U.S. Federal Deposit Insurance Corporation (FDIC), securities made up 21% of lenders' assets as at the end of March. A great many of these holdings have plummeted in value and billions of dollars in unrealized losses are going to be reflected in the various capital calculations.
Bruce Thompson, Bank of America's chief financial officer, thinks that the Bank will need three years of net interest income to replace lost capital.
There is also the fact that banks have gradually become substantial bond traders for their own account and been able to generate significant profits. We have been accustomed to seeing these earnings. Now, heading into a fixed-income bear market, bond trading is bound to become less profitable. There may even be net losses. As you can see, there are lots of uncertainties.
U.S. bankers worried
CEO Jamie Dimon of JPMorgan Chase told a Fortune Global Forum: "The return to more normal interest rates is going to be scary and kind of volatile". It's not the sort of forecast you expect from a leading banker. We have been warned.
In fact, U.S. bank executives are concerned right now with new regulations as well as rising interest rates. They are strenuously complaining about expense controls, sound balance sheet rules, and credit loss provisions, the sort of standards we take for granted here in Canada. American bankers feel that all this red tape is hampering their operations but it's all long overdue as far as investors are concerned. In any event, the U.S. banking industry is showing signs of strength despite all the rules.
Industry top-line growth remains sluggish but banks have been gradually easing their lending standards and introducing higher fees in order to improve profit margins. Mortgage business has slackened recently as the refinancing boom fizzles although this is being partially offset by increased loan interest rate spreads. Wall Street analysts feel that U.S. banks, like their Canadian counterparts, are likely to struggle for a while but then grow more rapidly in 2014 and beyond.
Looking ahead, rising interest rates and increased loan demand should drive earnings as the recovery gains momentum. There are also other revenues coming on stream. Analysts expect to see more income from prepaid cards, higher minimum balances, and innovative credit cards. Cost-cutting continues and there have been more than half a million lay-offs during the last five years.
It all sounds promising but we have to keep one thing in mind. The American banking system is quite different to our tightly-knit, controlled Canadian banking industry. These are not defensive income stocks, although some of them fall into that category. There are bank failures, something that we rarely see in this country. During the second quarter of 2013 alone, 12 American federally insured banks failed. Last year there were 51 bank failures and that is just the tip of the iceberg. As of March 31, the FDIC had 612 U.S. banks on the "problem list".
I am not saying that American banking stocks are speculative, merely suggesting that you should tread carefully when assessing these companies. It's a sprawling, diverse industry with a lot of pitfalls. There are about 7,300 insured banks in the U.S. and hundreds of them are publicly traded. As a matter of fact, investment houses tend to group them in sections such as Banks - Southwest or Banks - Major Regional. It's easy to choose a stock that is really a special situation or heavily dependent on a unique regional economy.
My feeling at this stage in the cycle is that we should stay with a group of the largest banks that make up what is known as the Diversified Financial Services sub-industry. These institutions are extremely well capitalized and we should see them returning excess equity to shareholders in dividends and repurchase programs next spring when the Fed's stress tests are complete. In addition, their substantial international and investment earnings could pick up the slack if the American recovery falters. Equally important, these major players have continuing analyst coverage. We will be able to keep close tabs on the progress.
The outlook
My feeling is that banks are going to have a relatively rough passage over the next few quarters. I am not suggesting that they are going to incur operating losses. However, their crucial loan growth, the industry's lifeblood, is like to remain tepid until the underlying economy picks up steam. Everything depends on whether the recovery has traction.
The outlook is mixed. According to the Conference Board, U.S. GDP should grow 1.5% in real terms this year while here in Canada we are likely to see an increase of about 1.7%. Those are tepid numbers. In 2014, however, the Board looks for a more robust 2.8% growth in the U.S. and 2.5% in this country. Not everybody agrees. TD Bank CEO Ed Clark thinks that "2014 is going to be a tough revenue year".
Some of the difficulties are already apparent in the Canadian banks' third-quarter earnings. Our media greeted these as an earnings bonanza but when you scratch the surface there is not much to cheer about. Many analysts had downgraded their forecasts, especially in the case of TD Bank, so the bar was low. It looks as though total industry cash operating income was up a modest 4% year-over-year. The numbers were good enough to support some modest dividend increases but these came with disappointing guidance.
You'll find updates on my bank recommendations elsewhere in this issue.
Bank of Nova Scotia (TSX: BNS) (NYSE: BNS)
Originally recommended on Jan. 17/11 (#21102) at C$56.83, US$57.34. Closed Friday at C$60.03, US$57.67.
Scotiabank turned in a solid performance despite some difficult international markets. Cash operating earnings, excluding unusual items of $1.32, were up 15% from $1.15 a year ago and slightly ahead of the $1.30 consensus forecast. A 3.3% dividend increase to $2.48 annually was in line with expectations. Canadian banking earnings jumped an impressive 14% year-over-year but a lot of that was due to the ING acquisition.
One of the main reasons we have BNS on our Buy List is the bank's overseas exposure. This time, though, the International Banking segment produced lacklustre numbers. Good loan growth was offset by higher loss provisions and increased expenses. I should point out that about 40% of this business is in Mexico and the Caribbean, areas that reflect the spluttering U.S. economy. This is a case of battling headwinds until the recovery has real traction.
Nevertheless Scotiabank remains my first choice amongst the Canadian banks because of the balanced growth opportunities abroad and improving numbers from the ING business here at home.
Action now: Scotiabank remains a Buy with a target of $65. I will revisit the stock if it dips to $53.
National Bank (TSX:NA, Financial)
Originally recommended on April 11/11 (#21114) at C$76.69, US$80.22. Closed Friday at C$82.91, US$79.74.
National Bank reported third-quarter earnings of $2.22 per share, a 12% improvement over $1.98 a year ago and well ahead of the $2.06 consensus forecast.
The story here was a $186 million trading profit while Wealth Management income of $58 million was up 26% year-over-year. Most encouraging, there was an 8% growth in personal and commercial loans. Another plus is that National has acquired TD's Institutional Services Unit, a move that should add as much as $0.12 a share to the bottom line next year.
A year ago we put National on Hold at $77 because of possible reaction to the Quebec election. That proved to be a good move and the stock subsequently dropped into the $72 range. Now, however, investors are more receptive to NA.
Action now: National Bank is reinstated as a Buy with a target of $90. I will revisit the bank if it drops to $75.
TD Bank (TSX:TD) (TD, Financial)
Originally recommended on Feb. 12/07 (#2706) at C$69.85, US$59.59. Closed Friday at C$92.16, US$87.55.
TD Bank earned a $1.60 a share in its third quarter versus an expected $1.53 but down substantially from $1.78 the year before. The numbers were a mixed bag. TD's insurance and wealth division essentially broke even compared to a $360 million profit in 2012 because of flood losses and poor auto experience. Wholesale banking earnings were $147 million, well below the $200 million analysts were expecting. On the plus side, personal and commercial banking in Canada as well as the U.S. turned in strong earnings and the bank announced a 5% dividend increase to $3.40 per share annually.
The insurance loss was a shock and a reminder of why for many years banks were expressly forbidden from offering insurance. With natural disasters occurring more frequently, investors are bound to factor this exposure into the stock price going forward. For now TD is back on track and expected to earn about $7.75 a share in 2013 and $8.50 or so next year.
Action now: TD Bank remains a Buy with a target of $100. I have set an $80 revisit level.
JPMorgan Chase & Co. (JPM, Financial)
Originally recommended on Feb. 3/13 (#21305) at $47.85. Closed Friday at $52.56. (All figures in U.S. dollars.)
Looking south, the U.S. bank that I particularly like right now is JPMorgan Chase, an industry leader with assets of nearly $2.4 trillion and operations in more than 50 countries. It functions with four business segments, Consumer Banking, Corporate Banking, Commercial Banking, and Asset Management. Annual revenues exceed $106 billion and last year JPM reported net income of $21.3 billion.
In June, the bank announced a second-quarter profit of $6.1 billion or $1.60 per share, up 32% year-over-year and a lot better than the $1.44 consensus forecast. Investment earnings of $2.8 billion surged 19% from the second quarter of 2012, driven by increased underwritings as U.S. financial markets revived. Mortgage applications jumped 37% to $67 billion. It was an excellent performance and JPM is now set to make about $5.90 a share in 2013 with an increase to $6.25 next year.
There is one cloud on the horizon. JPM has been receiving a lot of bad press recently and that is likely to continue for a while. The Justice Department is probing the bank's trading practices and there are lawsuits pending.
However, it's worthwhile keeping in mind Chase's strong balance sheet and enormous income when any settlements are announced.
Action now: JPMorgan Chase remains a Buy with a $65 target. I have set a $42 revisit level.
