Download PDF Version – Banking on Dividends
Royal Bank of Canada and Bank of Montreal
What are the odds?
The Canadian banks continue to be viewed widely as buy-and-hold winners. If the stock itself doesn’t increase than there’s always “the dividend”. I love dividends as much as the next analyst but when a stock produces no returns for an investor, including dividends, for five to seven years, the argument loses power in my view. In this piece we’ll have a quick look at why I think that all the Canadian bank stocks are likely to revisit the lows they hit in March or possibly much lower, leaving investors holding the bag wondering why they were in them to begin with. For patient investors, I expect this to create a rare long-term buying opportunity later this year or into 2021. Let’s have a look at the backdrop for the banks, with a focus on RBC and BMO.
I remember very clearly in 2008 having a discussion with an analyst who I respected. I asked about the risk that the financial crisis posed to Canadian housing and the Canadian banks. He suggested that the current environment (2008) was not overly threatening to either and that what we really needed to watch in both regards was Canadian unemployment.
At the time of the Great Financial Crisis, as we now fondly remember it, it wasn’t so much about a slowing economy. People were still working and business continued, even if a lot of money was lost investing in leveraged US mortgages. Today, however, is different.
The following chart, taken from the St. Louis Federal Reserve, shows Canada’s unemployment rate back to 1960. No, that line is not a misprint. History shows us that in recessions, some of the temporary job losses become permanent. The current employment recession is by far the worst recession since WWII in percentage terms, and the worst in terms of the unemployment rate.
As temporary job losses become permanent, the percent of permanent job losers will probably continue to increase for some time.
Anything is possible. Maybe this will be a V-shaped recovery and unemployment in Canada will drop as fast as it increased. Personally, I don’t see how that is going to happen with all the “helpful” government programs incenting young people to stay home and not work. But I digress.
With this backdrop, consider how much debt Canadians are carrying. BMO economist Priscilla Thiagamoorthy said pre-COVID that household debt was a key vulnerability for the economy. Household debt as a proportion of household disposable income recently hit 176.9%. In other words, there was $1.77 in debt for every dollar of household disposable income.
Statistics Canada added that annual trends show that lower income households tended to have an even higher debt-to-disposable-income ratio.
Many Canadians, knowing that we are much more prudent and wise than our glutinous American cousins, are shocked when they see that after 2008, Americans decided to reduce their household debt as a percent of disposable income, while we decided to continue growing it.
Canadian bank financial statements:
A quick search shows that a sluggish economy has resulted in higher 90+ day delinquency rates (the percentage of credit users that have missed 3+ payments). The delinquency rate rose to 1.19% (an 11% increase) for non-mortgage debt, the highest mark since 2012. British Columbia (up 14.4%), Ontario (up +14%) and Alberta (up 13.3%) led the way higher. Alberta in particular has erased all of their previous recovery and delinquency rates are now back above their 2016 level.
Veritas Investment Research is an independent equity research firm. Independent means they do not get paid to participate in underwritings to raise money for issuers, so their opinions are their own and not pressured by conflict of interest as it relates to the next underwriting needed by a company in question.
Veritas has a long history of being rather correct about their assessments of the value of stocks they study, even if their timing may not be the greatest. Recently they’ve reported that Canadian banks have seen $100s of billions of credit, both mortgage and otherwise, in deferral. Deferral refers to consumers applying, under the new “Covid-era” provisions to not make their loan payments and to defer them to a later date. While some of these applications may just be people being prudent given the generous, government-encouraged payment freedom plans, these things eventually come home to roost.
Recently Veritas reported that Canada’s Big Six banks have extended their deadlines to apply for deferrals until the end of September, signaling that retail borrowers remain under financial stress. On the surface, this belies the V shaped recovery concept, at least in Canada. They report: “Banks may classify deferred loans as performing. However, after the initial six-month period elapses, deferred loans will begin to migrate to non-performing. Ultimately impairments will determine peak credit losses once banks move past the ‘deferral cliff’ in September. “
Who knows? Maybe none of it matters but when we look at the supply/demand picture for Canadian bank stocks, which we do next, I somehow doubt that.
Royal Bank of Canada and Bank of Montreal: Supply vs. Demand
Generally, I don’t like what I have been seeing from any banks, and that includes the Canadian Banks.
Looking at RY & BMO, the demand-side buying pressure for Royal Bank is now negative as is its internal strength. The rally from the March lows was unable to generate an RSI(14) over 70 suggesting little buying power behind the name. Is that a precursor to more trouble for the stock & global economy? It’s hard to say, but a picture says a thousand words. You just have to know what to look for and right now, these pictures say to me there are a lot of bankruptcies coming.
Our views could change but I would have to see a lot of improvements in longer-term chart attributes to turn fully Bullish and that doesn’t look like it will happen for a while.
Looking at the move from the March lows, RY and BMO have not been able to breach and hold above their 35-week moving averages. Royal got close but has been rejected there again.
Don’t misunderstand our position. The Canadian banks will be fine, even though I think they’ll be fine after they reach lower prices. Our job is to harness the power of probability and put the odds on your side. Currently, odds are lining up against the Canadian banks.
For the broader market, internals are not supportive of a longer-term bull market. RY and BMO stocks both are losing internal strength, have been rejected by their longer moving averages, which are both still sloping down, volume is showing little interest in a rally for these names and they face a fundamental backdrop as bad as any credit cycle they’ve faced in decades.
My expectation is that Canadian bank stocks will reach levels that will have provided investors with no returns, including dividends, for close to a decade, late this year or early next year.
In our view, your odds are much better in other assets.
Also, for those investors sitting on long term capital gains which you are afraid of realizing, consider these two points:
- We believe our tax regime in Canada is under review. One thing we can be certain of is that our federal government is looking for ways to increase tax receipts. I’ve heard that capital gains tax increases are on the table meaning disposing of stocks with unrealized gains may cost more in the future.
- A unique vehicle exists which allows investors to dispose of stocks with large unrealized gains by diversifying into other investments while NOT triggering capital gains.
If you are interested in learning about that tax deferral and diversification mechanism for unrealized capital gains, or if you would like to see our detailed technical report on RY and BMO, feel free to reach out.
Peter Schenk, CMT
Senior Portfolio Manager