Investors have been selling Canadian bank stocks on the back of rising interest rates, and fears of a recession. However, the fundamentals at these financiers signal that investor worries might be overdone.
Recession risks have dragged on bank stock returns as investors have become less optimistic about the economy having a soft landing in the current inflationary environment, says Morningstar senior equity analyst Eric Compton.
Year to date, the TSX Composite Banks index is down 13%. The Morningstar Canada index and the S&P TSX Composite index are down 8.6% and 10.3% for the same time period. The six banks in our coverage universe have fallen between 4.8% (Royal Bank of Canada RY) and 13.3% (Bank of Nova Scotia BNS).
“The sector is cheap right now because of recession concerns. No one wants to own any stocks in a recession in general, and no one wants to own economically sensitive sectors like financials in a recession,” Compton explains, adding that as recession risks change, so will Canadian bank stock prices.
Which are the Best Canadian Bank Stocks to Buy Now?
The recent market correction has left many bank stocks trading at attractive valuations, leaving significant room for a margin of safety. Of the six Canadian bank stocks covered by Morningstar analysts, five are considered undervalued, with a Morningstar Star Rating of 4-stars. Additionally, all of the banks have either a wide or narrow Morningstar Economic Moat Rating, which means that Morningstar believes these banks have a competitive advantage that will protect their excess returns on capital for the next 10 years (in the case of Narrow moat stocks) or 20 or more years (in the case of Wide moat stocks)
For Compton, his top pick is National Bank of Canada (NA). “National Bank of Canada tends to fly under the radar because it is the smallest of the group – in fact it is less than 1/6th the size of RBC, the largest. However, its return on earnings is consistently the best among the group, and its overall growth rates have tended to also be above average. It has more room to grow than the others because it is still on the smaller side. Combine that with it being the cheapest valuation, and I like NBC as my top pick,” he says.
How Likely is a Recession in Canada?
Canada has experienced five or six recessions of varied impact and duration since 1970 depending on the definition. Recessions are relatively rare but not unprecedented.
As Morningstar Investment Management’s Mike Keaveney says, “It is reasonable to think that there is an elevated probability of an upcoming recession in Canada compared to normal, but it isn't a foregone conclusion or even the base case.”
Some of the indicators to which he points include successive rate hikes from the Bank of Canada to rein in inflation, especially given that rate tightening cycles have resulted in recessions in the past. “GDP growth has also slowed with measures of first-quarter growth in Canada coming in below previous rates and below consensus expectations. Plus, domestic investors can't just focus their attention on local activity, so, global supply chain issues, elevated commodity prices and the uncertain continued path of a global pandemic factor into the equation,” he adds.
Compton is not worried about a recession in Canada, “I think Canada will be able to handle it, but it is a real possibility that investors should be prepared for,” he says.
What do Recession Fears Mean for Canadian Banks?
If investors should prepare for a recession, and Canadian bank stocks are undervalued at the moment, does this mean that the impacts of interest rate hikes and the threat of inflation are priced in, or could Canadian bank stocks fall further?
Compton doesn’t rule out a further drop. “As recession sentiment has gotten more intense, people have gotten less optimistic about the economy having a soft landing. As that sentiment gets worse, the market has fallen, and the banks, which are recession-sensitive, are not immune to that. If a recession does materialize, I think the Canadian banks would fall even further from here, they have not fully priced in a recession just yet,” he says.
While Compton does not currently model a recession for his base-case fair value estimates, he notes that for long-term oriented investors, it may not matter.
“Recessions do take away earnings in year one, and depending on how long the recovery takes, maybe more, but we generally have a recovery to where we were forecasting [prior to a recession],” he says. “If we did forecast a recession in our base case, it would probably result in a low single-digit percentage impact to our fair values on average.”
