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Canadian bank stocks are struggling as investors fret over the possibility of an oncoming recession, but some analysts believe that banks are not yet reflecting an ugly economic downturn.

Share prices of the Big Six banks – Bank of Montreal, Canadian Imperial Bank of Commerce, National Bank of Canada, Royal Bank of Canada, Bank of Nova Scotia and Toronto-Dominion Bank – are down 11.7 per cent this year, on average. They are underperforming the benchmark S&P/TSX Composite Index, which is down about 10 per cent over the same period.

The correction in banks stocks is part of a broader downturn in equity markets this year, as central banks raise interest rates aggressively in an attempt to bring down inflation – even if it raises the risks of a global economic contraction.

That’s not good for bank stocks: Banks need a robust economy to stoke demand for new loans and give borrowers the financial ability to make payments on existing ones.

Long-term investors may have little to worry about here. Declining share prices have boosted dividend yields to an average above 4 per cent, rewarding patience.

Plus, analysts expect that even gloomy economic scenarios probably won’t have a devastating impact on bank profits. That’s because banks have less exposure to risky loans than in 2019 and remain well-protected with previous provisions.

“The stocks aren’t trading on the earnings-per share revisions. They are trading on fear,” said Gabriel Dechaine, an analyst at National Bank Financial, in a research note.

The thinking here: Profit expectations this year have actually risen by 4 per cent, based on the average analyst estimate. However, the average price-to-book ratio – a popular valuation metric for bank stocks – has declined by about 24 per cent from a recent peak in January, suggesting that the dismal outlook is overshadowing earnings forecasts.

A lot of investors no doubt are worried about rising provisions for credit losses, or PCLs, as banks sock away money to cover rising loan losses that come with a deteriorating economy.

PCLs spiked near the start of the pandemic, pushing the banking regulator to order banks to conserve capital by halting dividend increases and share buybacks.

But Mr. Dechaine believes that the downside risk to profits, should loan loss provisions rise halfway to levels seen during the peak of COVID-19 lockdowns in 2020, is about 5 per cent over the next six quarters – which he calls “not that scary.”

What’s more, this risk is partially offset by a number of factors that should help banks. Rising interest rates, for example, raise the profit margins on loans. Strong energy prices support the commodity-heavy Canadian economy. And the second half of the year is typically a strong period for banks.

Still, that doesn’t necessarily mean that Canadian bank stocks are strong buying opportunities right now, according to analysts.

The reason: Although valuations are beginning to price in an economic slowdown, they are not reflecting a recession, suggesting that valuations can contract substantially more as gloom sets in.

“If ‘the market’ is convinced there is a recession on the horizon, it does not show in the valuations,” said Darko Mihelic, an analyst at RBC Dominion Securities, in a note last week.

In a recession, Mr. Mihelic said, his 2023 earnings estimates for large Canadian banks would likely decline by at least 16 per cent, on average.

Banks’ common equity tier 1 ratios, the financial buffer that banks must maintain, would likely bottom out at 11.2 per cent, down from an average 13 per cent after the banks reported their fiscal second quarter financial results in May.

While that’s not enough to worry about the need for raising capital, it likely will mean that banks will halt dividend increases and share buybacks.

Perhaps more worrisome, Mr. Mihelic estimated that valuations would continue to shrink as earnings expectations decline.

Bank stocks currently trade at about 9.8 times estimated 2023 earnings, he said. That’s still well above the trough price-to-earnings ratio of 8.8 during the low point of the pandemic in 2020, and 7.8 during the 2008-2009 financial crisis.

The takeaway? Though bank stocks are down from their highs, things could get worse before they get better.

“Until recessionary concerns fade, inflation tempers or the housing market shows signs of a recovery, we believe the sector has more downside risk than upside risk,” Mr. Dechaine said.

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Tickers mentioned in this story

Study and track financial data on any traded entity: click to open the full quote page. Data updated as of 27/03/24 4:00pm EDT.

SymbolName% changeLast
BNS-T
Bank of Nova Scotia
+1.4%69.42
BMO-T
Bank of Montreal
+0.32%130.77
TD-T
Toronto-Dominion Bank
+1.52%82.27
CM-T
Canadian Imperial Bank of Commerce
-0.66%67.9
RY-T
Royal Bank of Canada
+1.12%136.23
NA-T
National Bank of Canada
+0.74%114.57

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