Buying the Banks Ahead of Earnings
by Craig on 24/10/09 at 9:16 am
The Canadian bank share prices have been range bound since their last earnings reports at the end of August. Last earnings season five of the six majors beat expectations and the group moved higher (CIBC was the only bank that missed expectations). There has been some reservation for the group given the plight of the U.S. Financials over the past year. Fortunately, the Canadian banks have managed for the most part to avoid many of the pitfalls which befell their peers to the south. And it is worth noting the U.S. banks have begun to rebuild balance sheets and generate significant earnings once again. Thanks in part to a generous government but also thanks to very low interest rates.
Steep Yield Curve
A significant portion of bank earnings are derived from the spread between the income from lending money and the cost the banks pay for the capital to lend. This is captured in Net Interest Income and is calculated by adding interest income plus investment income less interest expense. Another important fact is banks tend to do more borrowing (cost of capital) based on shorter term interest rates and lending tends to be, on a relative basis, focused more on longer term rates (income from lending). We have found there is a relationship between bank earnings and the spread between short and longer term interest rates or the steepness of the yield curve. (note: for a definition of yield curve please see the end of this report)
While there are many factors at work in a bank’s quarterly earnings report given their size and breadth of operations, it seems the steeper the yield curve the better. Comparing the slope of the yield curve based on 10-year government bonds and 3-month T-bills, the steeper the curve the better the quarter-over-quarter earnings growth of the banks (chart). Currently, with T-bills yielding 0.28% and 10-year government bonds yielding 3.51%, the curve is very steep with a slope of over 3%. Since 1993 when the slope is over 3 percentage points only once was there negative earnings growth (-2%) and the average earnings growth was positive and in the double digits. Given the slope, we should see some decent earnings growth next quarter from the banks.
Current Earnings Estimates
Based on consensus estimates compiled by Bloomberg, the average earnings growth for the group is just above zero at 0.9%. Clearly the market is not expecting much from the bank’s next reporting period. With the economy continuing to show signs of improvement and the steepness of the yield curve, we believe the Canadian banks are well positioned to exceed expectations this earnings season as they did last.
Investment Implications
The banks have recovered considerably from the March lows along with the broader market. But the market, as measured by the S&P/TSX Composite, has risen another 5% since the end of August while the Bank index has fall 1%. The group now has an average yield of 4.4% which is very attractive given prevailing interest rates. Once more, there is less risk or probability of the banks cutting back on their dividends as was feared a few quarters ago.
Digging a little deeper into last quarter’s results, Bank of Montreal (BMO; $52.03), Toronto Dominion Bank (TD; $64.97), Bank of Nova Scotia (BNS; $46.34) and Canadian Imperial Bank of Commerce (CM; $64.36) appear to have greater exposure to Net Interest Income. Although this does fluctuate from quarter to quarter.
From an ETF perspective the iShares CDN Financial Sector Index Fund (XFN; $21.70) is weighted 69% towards the big six banks providing a little more diversification.
Note the banks do not begin to report earnings until late in November. Waiting for some weakness or buying some now and some later in November may prove more opportune.
Yield Curve Definition
The yield curve is the relationship between interest rates and time to maturity. For the government yield curve, the most widely used, it is comprise of taking the yield on Treasury bills and government bonds of varying maturities and linking the yields together. What is produced is a line of yields based on the term of the bonds, the yield curve. The yield curve does not just encapsulate bond market yields, it also provides some insight into the market’s expectations of the overall economy. In a steep yield curve environment, the market believes interest rates will be rising in the future. This is commonly driven by expectations of greater economic activity and/or inflation. When the yield curve is flat or inverted (longer term yields are lower than shorter term yields), the market is expecting economic growth or inflationary pressures to lessen over time. There is considerable evidence that yield curves can be a leading indicator of earnings growth for the entire economy. But that is for another report.
