29 July 2018

Banks are About More Than Just the Housing Market

The Globe and Mail, Andrew Willis, 29 July 2018

Canada’s housing market is something of a national obsession. It’s understandable. It’s also misguided when it comes to Canada’s banks.

It’s all very well for renters to dither about jumping in, or homeowners to fret about what their place will be worth after their kitchen reno. But along with being a tad tedious, all this talk is distracting investors from fundamental improvements in the fortunes of the big banks.

Canada’s big banks report quarterly financial results in August. Analysts are out with previews of the numbers that focus, predictably, on each institutions' exposure to the mortgage market. To sum up all this analysis in one line: No one sees residential real estate as a major concern.

CIBC World Markets Inc. ran something of a doomsday scenario, determining what would happen to profits if the banks suddenly stopped expanding their mortgage portfolios, which are perceived as a critical source of earnings. If growth in mortgage lending dried up completely, which is highly unlikely, CIBC analyst Robert Sedran determined the banks’ future profits would drop by just 1 per cent. “We view slowing mortgage growth as a very manageable headwind," Mr. Sedran said.

“It seems that whether we are late cycle or late-late cycle, the market is more preoccupied with what might go wrong in coming periods than what went right in the last one,” Mr. Sedran said. This backward-looking approach, he said, means investors miss out on the potential of new business initiatives under way at each of the big banks.

While the rest of us were trading stories about a friend of a friend who made millions flipping houses, the big banks rolled out international growth strategies that have nothing to do with Canadian housing. It’s worth noting that each bank is on a very different path.

Royal Bank made a big bet on wealth management in California. Bank of Nova Scotia did three more acquisitions in South America this year, adding to a massive regional platform. Canadian Imperial Bank of Commerce bought a Midwestern U.S. retail network, while Bank of Montreal expanded its U.S. commercial banking franchise.

In the past, results from these forays were overshadowed by strong performance from the banks' domestic businesses. That’s understandable, as even large acquisitions can take several years to make an impact on a bank’s profit. That’s about to change. Mr. Sedran said expansion strategies are starting to make a meaningful contribution to earnings growth, which in turn will boost stock prices.

Which bank has the best growth plan, and is poised to deliver the strongest results? That’s where things get interesting, as analysts can’t agree on who has winning strategy.

It’s likely one or two banks will outperform rivals owing to the success of their foreign investments. That’s a contrast to forces such as interest-rate moves or loan losses – the big waves that tend to wash across the entire sector. Potential gains on foreign investments are significant. Approximately 40 per cent of earnings growth at Bank of Montreal is expected to come from its U.S. expansion efforts, while Royal Bank’s wealth management platform is expected to account for 20 per cent of growth in profit, according to CIBC’s analysis. That means a bank with a successful strategy can break away from the pack.

Favourite picks from CIBC’s Mr. Sedran are Toronto-Dominion Bank, with a strong U.S. retail network that stands to benefit from tax cuts, and Scotiabank, for its South American exposure. Over at RBC Dominion Securities Inc., analyst Darko Mihelic favours Bank of Montreal, based on the potential of its U.S. commercial banking business.

In looking at growth strategies at banks and other public companies, analysts often highlight the potential for “multiple expansion.” It means that, over time, investors will put a higher value, or multiple, on each dollar of profit. In a recent report, Mr. Mihelic said, “BMO has a relatively smaller exposure to a potential slowdown in the Canadian economy and we see good upside as BMO may be the only stock with some multiple expansion potential.”

Canadians are going to keep speculating that a $1-million price tag on a run-down Toronto semi-detached with no parking is a sure sign of a real estate bubble. They may be right. But our obsession with housing shouldn’t distract from the potential for higher profits from the country’s banks.

11 July 2018

Why Bank Investors Should Shudder with Each Rate Increase

The Globe and Mail, Ian McGugan, 11 July 2018

The Bank of Canada’s interest-rate decisions, often a rather humdrum affair, are becoming downright fascinating. The announcement on Wednesday of a hike, and the growing probability of more before year-end, suggest that the future will be very different than the past for Canadian banking stocks.

While the latest increase was widely expected, the tone of the announcement “was more hawkish than markets expected,” according to Derek Holt of Bank of Nova Scotia. He is counting on at least one more rate hike this year and would not be shocked to see two.

If this occurs, it would mark a significant turning point, both for the BoC and for the Canadian economy. Over the past quarter-century, and even more so over the past decade, Canadian households have borrowed with abandon as rates have generally headed lower.

Now that the economy appears to be running close to capacity, the central bank is faced with the difficult task of raising rates at a time when household debt burdens are massive by historical standards. Every upward tick in interest rates magnifies the burden of carrying all that borrowing. But the BoC appears increasingly confident that consumers can bear it.

Others have their doubts. The Parliamentary Budget Officer (PBO) warned in a report last year that “the financial vulnerability of the average Canadian household would rise to levels beyond historical experience” if rates climb as it expects over the next few years.

Some investors have their issues as well. In a report last month, Veritas Investment Research in Toronto said the pass-through of higher interest rates to highly indebted households will “drive higher delinquency rates and credit losses among Canada’s Big Six banks.”

The math behind these predictions is straightforward. It rests on the debt-service ratio (DSR), a measure of how much of a household’s disposable income goes to paying off loans, both in terms of principal and interest. The DSR was typically around 12 per cent in the 1990s and early 2000s. After the financial crisis, however, as rates tumbled and borrowing became more attractive, it jumped up to about 14 per cent.

What will happen if borrowing rates tick up by a percentage point over the next couple of years? Canadians owe an average of 168 per cent of their disposable incomes, so, all things being equal, a one-percentage-point bump in interest rates would result in a nearly 1.7-percentage-point increase in the DSR. This would leave the DSR close to 16 per cent, a level not seen in Canada before.

For its part, the PBO report predicts the DSR will hit 16.3 per cent by the end of 2021. To be sure, this ominous forecast could be disrupted if Canadians suddenly start vigorously paying off their debts or incomes jump upward. But whichever number you choose, the logic is clear: As more and more money goes to servicing existing debt at higher rates, less will be left for spending on everything else – or for servicing new debt.

For investors, this suggests Canadian bank stocks should be approached with caution. The Big Six and other lenders have thrived over the past quarter-century as households have more or less doubled their debt levels in relation to their disposable incomes. But if we’re entering a period in which loan growth will be slower, and default rates will rise, bank stocks look distinctly less shiny.

The housing market, too, is likely to feel headwinds. And there’s also the effect on the broad economy as the DSR grows. Veritas calculates that consumers are likely to see a significant slide in their spendable incomes as a result of higher borrowing costs. “We would expect these income effects to have materially negative implications for Canadian household discretionary spending and Canada’s overall economy,” it says.

To be sure, the BoC is aware of all these issues. Governor Stephen Poloz gave a speech in May in which he examined the issue and expressed confidence the central bank can manage the risks. Other countries, such as Norway and Australia, have even higher levels of debt in relation to incomes, he pointed out.

The central bank continued its confident tone on Wednesday, arguing that higher oil prices offset increased trade tensions and that the housing market is stabilizing nicely. So everything is good? Perhaps. But investors counting on a continuation of bank stocks’ endless good fortune may want to temper their expectations.

10 July 2018

The Next, Crucial Battle in Wealth Management: Banks’ Concentration of Power

The Globe and Mail, Tim Kiladze, 10 July 2018

Six years ago, Canada’s securities regulators stunned Bay Street by launching a review of mutual fund fees. Justifying the probe, they cited research showing these fees are “among the highest in the world” and noted that many advisers do not tell their clients about these costs.

In late June, after multiple rounds of consultations, the watchdogs finally released their recommendations. They landed with a splat.

After so many years of study, the only major proposal was a ban on deferred sales changes. Trailer fees − controversial, annual charges paid by investors to financial advisers, for simply investing in mutual funds − live on.

The verdict is a blow to investors. These annual fees often consume 1 per cent of assets invested in a fund, and they serve as a steep tax on them.

Although the study now feels complete, it shouldn’t be the end. There are still other avenues for regulators to pursue. At the top of that list: the increasing concentration of power in wealth management among the Big Six banks.

Historically, Canada’s banks were second-rate players in this corner of the financial-services industry. Wealth management used to be dominated by non-bank fund managers such as AGF Management and Mackenzie Financial and independent brokerages such as Nesbitt Burns and Wood Gundy.

Methodically, the banks bought and built their way into a dominant position over a few decades, first by scooping up full-service adviser networks in the 1980s and 1990s, then by turning their attention to asset managers such as Phillips Hager & North (acquired by Royal Bank of Canada in 2008) and DundeeWealth (bought by Bank of Nova Scotia in 2011). Toronto-Dominion Bank’s plans to purchase Regina-based Greystone Managed Investments Inc. for $792-million in cash and stock is a continuation of that trend.

The Big Six now account for almost half of long-term mutual fund assets − a proportion that continues to grow − as well as 53 per cent of net mutual fund sales so far this year, according to Strategic Insight, a consultancy that studies the asset management industry.

Has the banks’ newfound power and scale resulted in a better deal for investors? Hardly. The Globe and Mail recently studied the 100 largest mutual funds in Canada, a list dominated by the banks, and found their fees have barely dropped over the last five years. The average decline in management expense ratios (MERs) for the 100 largest funds was just 0.05 of a percentage point, and the average MER is still 1.99 per cent.

About half of those funds are managed by banks. At the top of the list were two RBC fund portfolios that, incredibly, held a combined $55-billion in assets as of Dec. 31. As these megafunds have grown, their expense ratios have not dropped at all, The Globe’s examination found.

A few independents, such as CI Financial Corp., maintain the heft, sales force and name recognition to compete with the big banks in asset management. But overall, independent firms’ ability to provide honest competition is weaker than it was, which makes it harder for startups with lower fees, such as Wealthsimple, or sometimes even global giants with low-cost funds to attract investors dollars.

The banks have such size that they can use their massive networks of bank branches and financial advisers to promote their own funds – and squeeze out rivals in the process.

“Being an independent in investment management isn’t easy,” said John Ewing, chief investment officer at Ewing Morris & Co, an independent asset manager. “The Canadian banks have a lot of different ways to influence investors.”

Sometimes, they take it too far. When asked about the issue of banks selling their own proprietary funds in 2013, Dave Agnew, head of Canadian wealth management at RBC, told The Globe: “We do not force any product, whether it’s in-house or not … to the clients within our wealth businesses in Canada.” This claim now has an asterisk on it. In June, the Ontario Securities Commission fined RBC $1.1-million for paying some of its advisers a better commission to sell the bank’s own funds between 2011 and 2016.

RBC says Mr. Agnew’s comment was not misleading. Non-RBC funds are still sold within the bank’s system. But while the bank may not “force” a fund on its customers, it was caught offering some employees 10 basis points more in commissions to sell in-house funds. Over five years, the OSC found that the enhanced compensation added up to $24.5-million.

“Money talks,” said John O’Connell, who runs independent asset manager Davis Rea Investment Counsel and was formerly a top financial adviser at RBC Dominion Securities. And the banks know it, he argues. “They have always used compensation as a behaviour control.”

This matters more than ever. Despite all the hype around low-cost, exchange-traded funds, mutual funds are still a big deal in Canada – they account for 36 per cent of the country’s $4.5-trillion in financial wealth, more than bank deposits. And the banks are becoming ever more powerful in this market, as they continue to scoop up competitors. Bank of Nova Scotia has been particularly acquisitive lately, buying Jarislowsky Fraser Ltd. for nearly $1-billion and MD Financial for $2.6-billion this year – two respected independents.

This consolidation is playing out against a new backdrop. For many years, banks have benefitted from a lending boom spurred by ultra-low interest rates. That phase is coming to an end. The lenders now refer to the “decade of wealth,” noting that baby boomers will be retiring in waves and they will need help with investments, which should drive growth.

Independent financial-advisory firms still have the highest number of advisers – about 30,000 of them. However, this segment of the market usually has clients with much smaller account sizes, according to Strategic Insight.

The banks, meanwhile, now have roughly 10,000 advisers located in their branches, who mostly sell mutual funds to the “mass affluent” market, or clients with, say, $50,000 to $250,000 in investable assets. Within the branches, banks can try to cross-sell funds to their banking clients, and credit cards and mortgages to their wealth-management clients. Facebook, some others – wield immense power. But abusing that scale, to the detriment of investors, should never be allowed to fly.