June 30, 2022

The place U.S. banks go, Canadian banks could observe.

That’s turning into a urgent concern after U.S. banking big JPMorgan Chase & Co. this week reported a pointy drop in its quarterly revenue, warned of potential financial challenges forward and watched its share worth decline to 15-month lows.

U.S. banks had been stable performers through the early phases of the financial restoration in 2020 and 2021, as mortgage losses subsided, employment ranges rebounded, buying and selling exercise surged and deal-making boomed.

However their share costs have been sliding over the previous six months amid issues that rising rates of interest might tip the financial system into recession. JPMorgan’s share worth has fallen 20 per cent this yr, underperforming the S&P 500 by 13 proportion factors.

That poor efficiency raises the query of whether or not Canadian financial institution shares – off their February highs however down lower than 1 per cent this yr, on common – will observe the U.S. lead.

In some ways, the backdrop for North American banks seems to be enticing proper now: The housing market is robust, credit-card spending is surging and the U.S. unemployment price has fallen to 2019 ranges.

What’s extra, central banks have begun to boost rates of interest, which ought to make lending extra worthwhile for banks and add a strong tailwind to their earnings.

Nonetheless, some financial institution executives and analysts have turned cautious in regards to the future – Jamie Dimon, JPMorgan’s chief govt officer, being one in all them.

Mr. Dimon warned in a current letter to shareholders that the confluence of financial stimulus through the pandemic, the necessity to increase rates of interest and the warfare in Ukraine “could dramatically improve the dangers forward.”

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In separate commentary that accompanied the financial institution’s monetary outcomes this week, he reminded shareholders that the street was something however clear.

“We stay optimistic on the financial system, at the least for the brief time period – shopper and enterprise stability sheets in addition to shopper spending stay at wholesome ranges – however see important geopolitical and financial challenges forward on account of excessive inflation, provide chain points and the warfare in Ukraine,” Mr. Dimon mentioned.

These aren’t idle ideas. The financial institution shocked analysts by setting apart US$902-million throughout its most up-to-date quarter, as a cushion in opposition to the specter of rising mortgage losses in america and repercussions from sanctions in opposition to Russia.

Its revenue for the quarter fell 42 per cent from final yr. Different U.S. banking giants reported comparable declines. Revenue at Citigroup Inc. fell 46 per cent, Goldman Sachs Group Inc. fell 42 per cent and Wells Fargo & Co. fell 21 per cent, weighed down in some circumstances by declining mortgage originations and funding banking charges.

Can Canadian banks, which can report their quarterly leads to Could, coast as their U.S. friends wrestle? Some analysts are beginning to surprise.

“Canadian financial institution shares are usually not being priced for a similar financial dangers which have already been integrated into the bond market and U.S. financial institution shares,” Paul Holden, an analyst at CIBC Capital Markets, mentioned in a be aware this week.

For instance, he identified that price-to-earnings ratios for Canadian banks are simply 4 per cent under comparable ratios for U.S. banks. The historic common is a reduction of 16 per cent.

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And he calculated that Canadian financial institution shares commerce at 1.8 occasions their e-book worth. That’s barely above the historic common of 1.7, regardless of what he sees as mounting financial dangers associated to rising rates of interest.

“Central banks will try to string the needle, balancing the necessity to tame inflation with out tipping the financial system into recession. Whereas we’ve little doubt central financial institution intentions would be the proper ones, we do should ponder the probabilities for error on both aspect of ‘excellent,’” Mr. Holden mentioned.

He expects that mortgage development will gradual to five per cent in 2023 from 10-per-cent development this yr. But when central banks increase charges too aggressively, triggering a recession, he thinks mortgage balances might contract by 4 per cent as indebted customers face pressures.

In a recession, Canadian financial institution shares might slide 30 per cent, he believes. That’s why he recommends shifting to lower-risk banks, akin to Royal Financial institution of Canada and Nationwide Financial institution of Canada, which have larger money buffers and extra diversified earnings.

Canadian financial institution shares have outperformed U.S. financial institution shares this yr. However the profitable occasions won’t final.

Full disclosure: The writer owns models within the BMO Equal Weight Banks Index ETF.

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