Transcript
Hello, and welcome to The Download. I'm your host, Dave Richardson, and it is a super special Stu's Days. Stu, I describe this Stu's Days every year as like, you remember when you were a kid and it's Christmas Eve and your parents tell you Santa is coming overnight. And you're sitting in your room with your brothers and sisters or whoever, the whole night. And you finally doze off. Then you wake up at five in the morning and you're at your parents for 2 or 3 hours trying to get them out of bed to go down and open the gifts because it's Christmas morning. That's what bank earnings are for you. And because I always held that against my parents, not getting up when my brother and sister and I wanted to get up to get the presents, we're taping this on Monday instead of Stu’s Days to get into it a day early. It’s that exciting for you, I know.
Yeah. It is always an exciting week. Some of them come out 5:30 in the morning and you’re with your glass of egg nogs, and stockings hung with glee or whatever. Last week, all the banks reported. Pretty reasonable numbers. The stocks have definitely been doing better in the last 6-9 months. We just run through some of the stats, net interest income, and many of the banks had expanded a little bit on the net interest margin side. Loan growth has still not been anything to write home about. And then the fee income was in many respects pretty good as well, across capital markets and market-related and investment-oriented stuff. So revenue is okay. And then the thing that we always have to talk about is provisions for credit. We talked about this before, how the accounting has changed. Banks take provisions on what they call impaired loans, and they also have provisions on what they call performing loans. The provisions on performing loans are very much driven by models. I have an expectation or range of outcomes that I see for the economy, and I have to put money aside for those expectations. And then when I actually have an impaired loan that starts to go bad, I might actually take a provision from the impaired, but I might say, well, the economy is actually starting to get a little bit better than what I thought, and I might release some of my performing loans, so they might cross each other off. In this most recent quarter, on the impaired side, we see the tail end of the consumer facing some of the challenges from higher interest rates. But at the same time, as rates come down and some of those scenarios about the future change, there wasn't quite as much performing loan losses that we've also seen. So the accounting has changed so we don't get this feast and famine quite the same way in the provisions for credit. And as we sit here today, as we go through 2025, probably some improvement continues into the back half of this year. The Canadian economic data has not been great. Unemployment is up to 6.8%. Those are the types of things where, when I talk about some of those assumptions, the assumptions might be 7%. You're still below the assumption, but it's still not a robust period for the consumer. And rates are coming down, but there's still a little bit of a of a pinch on mortgage renewal and things like this, even where we sit today. And so the Canadian economy is in a bit of a malaise. Bank of Canada is likely going to cut interest rates again. And the positive, if there is a positive in this, is that just like the Canadian economy was quite sensitive to rising interest rates, hopefully it will respond to slightly lower interest rates into next year.
That leads to a whole bunch of questions, for me anyways. The first is on these two types of loan loss provisions. You as a portfolio manager, and obviously you've got analysts working with you, and you're trying to understand where profits are going across all of the major Canadian banks, is that an area you focus on, particularly where you're running your own models to try and guess or understand potentially where those loan loss provisions are going to be quarter to quarter, but more importantly, year over year and into the future? Or do you have a bunch of overall assumptions on the profitability of the bank, and it all works out by the time you get to that level? Are you running a specific understanding of the provisions?
Well, the banks are pretty good about telling you what they think the provisions will be. It's not that you're necessarily taking them at their word, but you're spending a lot of time saying, what were their provisions relative to what they said? If they're in line with what they said, that means that the credit is evolving inside their book the way that they imagined. If it's way worse, then something's happening inside the book, and we have to be more concerned about that. And if it's better, then you want to get into the conditions of it. Which bucket is it better? I think the other thing that we really watch for is if these performing loan losses are based on what the bank thinks is going to happen. If all of a sudden, a bank out of the blue put up a huge performing loan loss, you'd say, well, what do you see that we don't? Why are you putting that? And sometimes there's model changes, but sometimes it's like saying, things might get a little bit worse, so we have to put a provision away in advance of that. That's not what we're seeing right now. We're seeing pretty benign levels of performing loan loss provision. So it's those two categories. An actual loan that's gone bad is called an impaired loan loss. And a performing loan loss is one where we're making an expectation about the future.
Okay. And then obviously, what's going on in the underlying economy is a big part of that. We've got the Bank of Canada lowering rates fairly aggressively. We've got longer-term rates that came down, backed up a little bit and have come down again. We're looking at an environment in the next year of likely, fairly significantly lower rates at the short end—what the Bank of Canada sets—and stable, maybe a little bit lower on the long end. You're getting a steepening of the curve. Under those assumptions, is that a really great economy or great yield curve for the banks? Or is that the fact that we've got rates coming down so quickly and what that says about the economy itself being weak, is that bad for the bank? See where I'm going with that? How does this all lay out as you're looking ahead now, 12 months out, which is what we really need to look at in in terms of what's going to happen with the Canadian banks?
Well, the ideal situation is for the yield curve to have positive slope because that's the bond market's way of saying that the economy is going to grow. So I want to get paid for some term premium. And that's a pretty good environment for banks. A lot of times when you see those charts, right as the yield curve goes back to being positive, which is when the economy is in the last stages of its malaise, and then once the bond market says monetary policy is going to work and farther dated yields start to back up a little bit higher than short term rates and you get positive slope in the yield curve, that's pretty good for banks with lending, all sorts of things. So that's usually a bit of a better environment for banks. And we can look out on the Canadian yield curve. A two-year bond is a one-year bond with a one-year bond a year from now. So you can always disaggregate interest rates. And when we look out in the future, we see a little bit more slope in the future than what's in the yield curve today. So that is saying to us that the environment is likely to get a little bit better, if that makes sense.
Sure. So the interest rate cuts have their effect. We were talking about before, how Canada is relatively sensitive to interest rate movements, the Canadian economy, because of the way debt is structured and particularly mortgages run in the Canadian economy with respect to the consumer. Those lower rates are going to, at some point, really start to kick in, we hope. If the US economy holds up, which is the other big thing because of our link to the US economy, then things could get, in theory, fairly decent. Is it fair to say that the banks are just a snapshot of the overall Canadian economy in general? Or is there a lot more going on in the balance sheets of the bank and their other business activities that doesn't make that the case anymore?
Well, a very large chunk of what they do is personal and commercial lending to the domestic economy, so you're definitely going to feel it. It's always at the edges that drive some of the relative performance on a more shorter-term basis. We talked about tariffs a couple of weeks ago. You may not find one large stand-alone business in the Canadian stock market that would necessarily be hit by tariffs. But if we get into a tariff situation that's more negative, it's going to ripple across all the businesses in Canada, which will then ripple across all sorts of business activity that the banks are exposed to. You're bang on. They're definitely exposed to the broader economy.
Yeah. In one of the future podcasts, I'll get Eric Lascelles on to talk about what happens when we become the 51st state. That's probably a different discussion, I would think. But Stu, the other thing that I find amazing then. We're talking about where the yield curves are moving now and where the economy might move now being potentially favorable for the banks. And then if we look over the last year, we were in an environment where you still had an inverted yield curve. You had these high short-term interest rates. And yet the banks have all done very well this year on the bottom line and then their stocks. And those are two separate things in the near term. How are the banks able to do so well in this environment over the last 12 months?
In part, you had a valuation change. The wild thing about the stock market in the short term is that very small changes in earnings can generate a more magnified return in the short term because if people have confidence in the earnings, then often the valuation can expand a little bit on top of it. I got earnings growth plus the valuation change. Over the long haul, we tend to get earnings growth and dividends and things like this. We've just been in one of those unique periods where 12 months ago, the valuation was quite low, and now the valuation is back to average, really. Maybe an inch above, but generally speaking, average. So that move from below average to average has been an incremental set of returns in addition to dividends.
Yeah. That’s one of the things I've been explaining because I've been doing all my speeches across Canada. And by the way, thanks everyone who came out to watch the events this year. I had another phenomenal year of attendance, Stu. One day we'll bring you out on the road, and then we'll get millions of people instead of the dozens that I generate. But it was the whole thing that you've talked about several times on the podcast. I always like to steal stuff from you. I think I attributed it to you a couple of times. But you know how you said, inflation peaks, 12 months later, interest rates peak. And we're talking about the interest rates that are set in market. So we highlighted the 10-year US Treasury that peaked in the first week of October of 2023. And then 12 months later is where you expect a bottoming out profits and economic activity. And I use this one, too. I also stole this one from you, Stu: the long nose of the stock market sniffing out. You're looking at last October and you're saying, well, why did the stock market just start this incredible run towards the end of October 2023? Well, it was looking out a year to where we are now. If this is the bottom of activity, once you hit a bottom, by definition, there's only one direction for things to go, which is up. So if it's looking out a year, it starts going up in advance, which is one of these things about the market that investors need to understand, all joking aside, that long nose is pretty good at sniffing out what's coming down the road, right?
Yeah. That's bang on. And those expectations, they shift through the piece. One of the things that we've talked about is the economic surprise index. It just reminded me, too, when you were talking about the night before Christmas—this is a great story of expectation—but I was dying for a hockey game, the ones where you twist the ends. And there's this big box beside the tree. And I kept saying to my mom, is it a hockey game? Is it a hockey game? And she said, well, I don't know. She did nothing to temper my expectations. And the next morning when I ripped open the paper, it was a piano, which was a great gift, but not what I expected. So that particular moment of Christmas was not likely my finest, as my displeasure with the piano over the hockey game. But the same thing has happened in the last 12 months on the economy. 12 months ago, people's expectations around the economy were quite poor. And as the data came in and it was a little bit better than just poor, it's been a very positive period of time. And then just in the last month or so, as economists have ratcheted up their forecast, and some of the data has been strong, but not necessarily stronger than a change in forecast, and we've seen that ripple through the bond market, this process of rates peaking has taken a few ebbs and flows. And it was just about a month ago when the US 10-year started coming down again. And that corresponds right from when some of this data started to be still strong, but not better than where some of the expectations lie.
Yeah. The surprise index, as you're saying, is where we would expect it a year out from where rates are peaking. Now, I guess we're looking for signs. We saw the jobs reports in Canada and the US that were okay. They may be a touch ahead of expectations in both cases, but with lots of noise in them and the unemployment rate still going up. So we're looking now over the next few months with rates coming down, to see some of the activity in the economy start to pick up, particularly, I would say, in Canada and the US in the employment markets.
Yeah, you're bang on.
So, Stu, we got a couple more episodes before the holiday season. We'll probably take a couple of weeks off, and then we'll go to the year-in-review episode, and then we'll get the exciting forecast in January from Stu Kedwell. Because I know Stu. Finally, he didn't get the hockey game that he asked for that year. He got the piano. But I know as an adult, he's been asking his wife for years for a crystal ball to predict the future of stock markets so that he could be even more accurate than he is in terms of managing money. And this could be the year that Stu gets his crystal ball for Christmas. And if he does, you're going to want to tune in and listen to our first podcast in early January to hear what Stu and the crystal ball have to say for the new year in investing. And that's why you want to subscribe to this podcast wherever you listen to it. Like us on YouTube now because we're on video. Comment on our hairstyles because this is the time of year you normally look at changing that. Maybe give us some ideas on our New Year's resolutions. I got to lose some weight. If you've been watching the video, you probably know that. Stu's in great shape. He exercises every day. But subscribe, like, give us a five-star review, and keep the marketing folks happy with us. Stu, another great episode. I'm glad you got through this exciting time of year without getting too excited. You seem fairly calm there. And we'll look forward to seeing you next week.
Okay. Thanks, Dave.