Canadian banks hit with downgrades as economic storm clouds gather

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Canadian bank stocks may be running out of runway amid an uncertain outlook and potential recession looming on the horizon, leading some analysts to slash outlooks and hand out downgrades.

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Barclays Bank PLC analyst John Aiken downgraded Royal Bank of Canada, Bank of Nova Scotia and Toronto-Dominion Bank on May 9, causing the S&P/TSX financials index to drop by one per cent.

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Shares of TD fell more than one per cent throughout the trading day and closed at $81.35 after Aiken downgraded the bank from “overweight” to “equal weight,” the equivalent of moving a stock from a “buy” to a “hold.”

RBC’s stock also fell more than one per cent to $129.43 after being downgraded from overweight to underweight and Scotiabank shares fell by just over two per cent to $65.88 after it was downgraded from equal weight to underweight. Aiken also slashed his outlook for the sector to neutral from positive.

Although some analysts argue that the Canadian banks haven’t been hit by the full brunt of the United States banking crisis, economic uncertainty ahead is raising concerns for the financial sector. Still, those risks are unlikely to show up when Canadian banks report earnings at the end of the month.

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“While we do not anticipate that the Canadian banks’ second quarter will demonstrate much earnings weakness, we believe that cracks in the foundation will become evident,” Aiken said in a note. “Further, with an uncertain outlook and a looming recession, we anticipate that there will continue to be pressure on the banks’ valuations and declining confidence in their earnings outlook.”

Aiken added that he’s still expecting loans to eke out some growth across the banks, along with help from a stronger rebound in the spring housing market. But he also thinks an expected recession will weigh on credit growth, even though it’s not a headwind the banks are facing right now.

Higher interest rates have been a double-edged sword for the banks because they’ve expanded net interest margins, giving banks the potential to earn more on interest at the cost of weighing on mortgage demand. Net interest margin — the gap between the interest income a bank earns through lending and the interest it pays out to lenders in areas such as checking accounts — has helped support bank earnings over the past few quarters.

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However, higher rates are also creating cracks in the foundation. Market watchers saw that play out in March when the collapse of the Silicon Valley Bank cast a shadow across the US regional banking space. The contagion may not have reached Canadian banks, but it’s a sign that the strain rate could increase bank results.

Canaccord Genuity Group Inc. analyst Scott Chan said in a May 9 note that Canadian banks are insulated from the US fallout. However, the Big Six banks have been underperforming the S&P/TSX composite index so far this year, after also lagging last year.

Heading into the second quarter, Chan said his team is lowering the bank group’s earnings-per-share forecast by two per cent on expectations of higher expenses and easing loan growth.

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Still, not all banks will be equally affected by macroeconomic headwinds. Chan upgraded the Canadian Imperial Bank of Commerce to a buy from a hold, on expectations of a 17-per-cent rate of return, outpacing the 10.4 per cent he expects from the entire bank group.

The Big Six banks will report second quarter results at the end of the month, starting with Scotiabank and the Bank of Montreal on May 24.

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