Ruth Saldanha: Hello and welcome to our limited-time series, the Morningstar Canada Outlook for 2024, where we will speak with Morningstar equity analysts and find out what they expect in this new year. Today, Eric Compton is here to discuss Canadian banks, a hot dividend favorite for Canadian investors. Sadly, this is also Eric's last conversation with us about Canadian banks as he moves to cover his new beat, technology. Eric, thank you so much for being here today.<
Eric Compton: Yeah, thanks for having me. It's great to be here. Sad it's my last time, but it's still good to be here today.
Canadian Bank Performance in 2023
Saldanha: Well, we'll miss you, but let's start by talking about Canadian banks in 2023. How did they perform? Were they in line with your expectations?
Compton: Yeah. So, for 2023, I would say a lot of things were in line with our expectations and there was one key area that was maybe a little disappointing. And so, going into 2023, we were expecting a more difficult macro backdrop, a more difficult credit backdrop, largely driven by higher interest rates. So higher rates leads to more of an interest rate burden on both consumers and companies. So, we were expecting that to play through in higher provisioning levels, higher credit strain, potentially lower growth. And we expected that and that has largely played out, especially in the last couple of quarters of the year. Now, the one area where it was a little bit disappointing compared to our previous forecast was on expenses. So, expense revisions were generally for higher expenses in the year, higher than what we were expecting. So, we actually did decrease our current values as the year developed by low to mid-single-digit percentages, largely due to those expense revisions.
Risks to Canadian Bank Stocks in 2024
Saldanha: Let's talk about some of the impacts that we might likely see in 2024 as a result of what happened in 2023. Now, in 2023, the banks raised their provisioning significantly to meet some of these drawbacks. Do you expect this to continue in 2024?
Compton: Yes, we do is the short answer. So, we think 2023 was kind of the initial start of this next credit cycle and 2024 will be a continuation of that cycle. So, with the Bank of Canada having raised rates and keeping them higher, you're going to start to see more of that pressure build in the economy. And one of the main ways that that's going to play out is through mortgages. And so, consumer debt levels have traditionally been fairly high in Canada. Debt service levels have been not quite as high because rates were lower. Now that rates have gone up, the typical mortgage in Canada, as I'm sure many of our listeners are familiar with, they reset on rate every five years. So, it takes time for that higher rate pressure to build up in the economy. So, on average, you expect about 20% of mortgages to reset each year. You're going to get another 20% in 2024. Mortgage payments on those are going to go up also about 20% of the average monthly payment. So, there's going to be more pressure on the Canadian consumer. We think that's going to decrease their ability to spend. They're going to have to take back some of that discretionary spending, put it towards the mortgage. And so, there's just going to be more pressure on the economy.
Higher rates also affect businesses. So, the banks are going to have to keep provisioning for that. You've seen some turn in some of the, I would say more of the – so provisioning is a little more forward looking. So that's one where you think it's going to keep building up. Some of the metrics that are maybe a little bit more about like the here and now of what's happening with credit. So just net write-offs where things have actually already gone bad. You've seen some upturn in that, some upturn in delinquencies, but those are largely still going higher or from like really low points. So, we think those still have a lot more room to go higher as well. So, you're looking out at 2024, continuing increase in pressure on the credit side, nothing that the banks can't deal with, but it's going to be there, slower loan growth as some of that discretionary spending that search for growth starts to come back. And then another item to really keep an eye on is that that expense development, which when you can't grow revenues as much, you got to focus more on expenses. I'll probably get into that a little bit more later, but that's like another thing we'll be really keeping an eye out in 2024.
Expect Pressure on Canadian Bank Expenses This Year
Saldanha: Yeah, let's talk about some of those things. What are some of the main things to keeping an eye out for next year?
Compton: Yeah. So, again, like a lot of these headwinds that we've already addressed a bit and that's like that debt build-up, continuing credit strain, like I mentioned, it's not anything that we don't think the banks can't deal with. It's just going to be a pressure on earnings. So, if you're looking for that like consistent 7% to 10% EPS growth or double-digit EPS growth for these banks, 2024 is probably going to be a year where that's harder to achieve for some of these players. Weaker GDP growth – Canada is not in a technical recession yet, but you are seeing some weaker GDP prints come out. For example, in the latest print from Q3, expenses – going into a little bit more deeper – but expense growth was higher in 2023. Some of the banks are trying to bring it back down in 2024. But some of the guidance has been a little bit mixed or not quite as definitive as maybe we would have liked. There's going to be some additional one-time charges as they try to right-size some of these like FTE or employee counts, things of that nature. So, we think there's still some residual pressure on expenses. Hopefully, it will be coming down towards the back half of 2024. That's another item that's like kind of a risk to earnings growth that we'll be keeping an eye on that we think we can play in 2024.
Expect Slow Dividend Growth in 2024
Saldanha: Now, what are all of these pressures, what kind of impact will they have on dividends? Because dividends is something that Canadian investors really, really care about. What's your dividend outlook for the Canadian banks?
Compton: Yeah, it's a great question. I mean, the Canadian banks are consistent dividend payers, and that's often a thing that investors in those names look for. So, typically, in a normal year, you'd like to see 7%-ish EPS growth plus or minus some years that are a little stronger, they get into the double digits. And usually, you want to see dividends grow with earnings with the stable dividend payout ratios. And so, last year, we saw closer to an average of a 7% increase. This year because of that increased earnings pressure we think the payout ratios are going to be a little more extended. And because of that, we think 2024 might be a year of slightly slower growth. So, we wouldn't be surprised if it's closer to 5%. Now, 5% or 7%, not that big of a difference.
To be honest, when you look at payout ratios, banks always have some room to maneuver each year. You can increase your payout ratio by just a little bit and get that extra couple of percentage points of growth if you want to deliver that year, especially if you've got confidence in the next year. So, I would just caution it's hard to get too precise with these things. But with that caveat in place, I do think the overall picture that 2024 is going to be a little bit more difficult on the EPS growth side, so maybe expect a little bit lower dividend growth in 2024. One where we think could be an outperformer is still – National Bank of Canada has one of the more payout ratios. So, that's one where you're trying to play maybe a bit of a higher growth there. That could be one to look at. Some of the other ones that might be a little more cautious. Like Scotiabank is one that's on our radar as maybe not as much room to grow their dividend. So, if we had to pick two to maybe focus on in that trend, I think those would be the two and then everyone else, I think, would be somewhere middle.
Morningstar’s Top Canadian Bank Stock Pick
Saldanha: That makes sense. So, going into this new year, what is your top Canadian bank pick and why?
Compton: Sure. So, at the start of last year, when we had this conversation, looking back at valuations back then, CIBC was the most undervalued name on my list. National Bank of Canada was also a bit more undervalued than the others. CIBC has actually performed decently this year compared to the rest on a relative total return basis. National Bank of Canada is slightly below average. But now both of those are starting to get closer to our fair values. So those aren't the most undervalued names on our list anymore. Royal Bank of Canada is another one where it just always seems to trade very close to our fair value. So, that's another one where we don't quite see the same discount. So, all that is set up to say, you've really got Toronto Dominion, Scotiabank and Bank of Montreal are the three that we see trading at the steepest discounts.
And so, looking at that, they are, just to give some numbers here, TD is more like a 15% discount; Scotiabank and Bank of Montreal are more like 11% to 13% range and the others are kind of like 10% less. So, TD is the most undervalued. BMO, Scotiabank are pretty close, slightly less undervalued, but it's all pretty close between those three. When I think about qualitative factors to pick among those three, TD does have a little bit more capital, excess capital, because the previous acquisition they were trying to get into didn't play out. So, maybe they've got a little more flexibility to be a little more aggressive on investments or share buybacks. So, that's one thing to keep in mind. I would probably favor BMO, Bank of Montreal, over TD just a little bit just because they're still working through realizing some of the synergies from the Bank of the West acquisition and they also have lower exposure to real estate. So, I think I like that set up better in today's environment, but TD maybe has a few levers they can pull too with that excess capital.
I think the one that's going to be in the toughest spot is going to be Scotiabank. So, they're actually just having an investor day today as we speak. They're really in a turnaround mode, likely going to be selling off or de-emphasizing certain segments and trying to re-emphasize others and that international footprint. So, I think that's going to be a multi-year story. So, from those three, my top pick would be Bank of Montreal, TD would be a close second and then I think Scotiabank might take a little bit longer to play out.
Saldanha: Great. Thank you so much for joining us, Eric.
Compton: Yeah, thanks for having me.
Saldanha: For Morningstar, I'm Ruth Saldanha.
