Central banks all aboard the rate hike train

Canadian banks have a first-class ticket

The rate-hike train is rolling, and central banks are all aboard. On May 4, the U.S. Federal Reserve Board hiked its federal funds rate by 50 basis points, to 0.75%. The Bank of Canada hiked its overnight lending rate, also by 50 basis points, to 1.5% on June 1. Central banks in the U.K., the European Union, and Australia have all raised rates. The rate hikes look set to continue, along with quantitative tightening, for the next few months, as inflation continues to wreak havoc, most notably and visibly on consumer prices. Canadian chartered banks look like they are along for the ride too.

Bond yields have risen in tandem, with benchmark 10-year government bond yields hitting 3% in Canada and the U.S. for the first time since 2018. Investors have become increasingly nervous about the effect this is having on equity markets. The selloff in the pandemic era winners, especially the large-capitalization technology stocks like Meta Platforms, Amazon.com, Apple Corp., Netflix, Alphabet, and Microsoft, has been brutal, with share prices sliding between 11% and 37% in the first part of the year. The biggest loser has been Netflix, which is down a remarkable 66% year to date.

Long-duration techs hit by double whammy

One of the principal reasons for the size of these declines is that these stocks are what are known as “long duration,” that is, a lot of their value is attributed to their rapid growth into the future, as reflected by their high valuations. If their growth slows, and the valuation placed on that growth is reduced by a higher price of capital (as reflected in interest rates) declines, then they are hit by a double whammy and prices can fall dramatically.

The question for investors is whether the same holds true for other less highly-valued sectors, such as utilities, pipelines, REITs, and financials. These sectors consist of stocks with reasonably high and sustainable dividends and relatively low valuations, as their growth rates tend to be highly correlated with the growth of the economy. Thus their price/earnings ratios are usually below that of the market as a whole, and often less than half those of higher-growth sectors such as technology. The combination of lower volatility and lower valuation usually tends to make them resilient during selloffs, and this has proven true again so far this year.

While the S&P 500 Composite Index is down 13% this year, and the tech-heavy Nasdaq Composite is down 23%, the S&P/TSX Composite Index, buoyed by its weighting to energy and financial sectors, is off only 2%.

Some investors point to the sharp drops in the big U.S. banks and worry that the same factors will hurt the performance of the Canadian chartered banks. The concerns are that the sharp rise in interest rates will cause a recession, rising unemployment, and a surge in bad debts. Given the sharp increase in corporate indebtedness, as companies took advantage of generational lows in interest rates, these fears are well founded. As Warren Buffet famously observed, it’s only when the tide goes out that you discover who’s been swimming naked.

Canadian banks cushioned

There are several reasons why the Canadian banks have both outperformed their U.S. counterparts so far in this interest rate cycle. Perhaps the most important is the oligopoly the Big Six banks enjoy, which leads to wider spreads and better margins. Rising interest rates are good news for banks, which raise their interest rates to depositors more slowly than the ones they charge their borrowers. However, if bad debts rise sharply, this benefit is negated.

Other reasons for the better performance of Canadian banks include their geographical diversification, their commanding position in asset management in Canada, and their large capital markets operations, giving them business risk that is not directly related to the interest rate cycle.

Year-to-date, Canadian banks are trading just a hair below breakeven, and all are ahead over the last 12 months, contrary to the experience of the U.S. financials. The removal of the Federal government’s restriction on raising dividends has undoubtedly helped too. One last reason for Canadian banks’ outperformance is Canada’s commodity exposure. Given that rising energy and materials prices are one of the reasons increasing inflation over the last year, a natural resource-based economy like Canada’s or Australia’s is much better positioned to gain benefits from this development, as occurred during the 1970s and the 2000s.

A couple of Canadian banks are standouts.

Royal Bank of Canada (TSX: RY) is Canada’s largest banking group by balance sheet and market capitalization (it’s larger than U.S.-based Wells Fargo, Morgan Stanley, and Goldman Sachs). It has leading positions in Canadian retail and commercial lending, asset management and investment banking. With the cap on dividends removed in the fourth quarter of last year, RBC raised its quarterly dividend 11%, to $1.20, giving it a yield of 3.5% and representing a 47% pay-out ratio. It’s an attractive addition to diversified portfolios, for its market-leading positions, growth in asset management, and strong capital base.

Toronto-Dominion Bank (TSX: TD) is the sixth-largest bank in North America by total assets, number of branches, and market capitalization. It has more branches in the Eastern US than in Canada and is one of the leading online financial firms, having merged its TD Ameritrade discount brokerage with Charles Schwab in the U.S. in 2020, leaving it with a minority stake in Schwab. After the removal of the dividend cap, TD raised its quarterly dividend 12.6%, to $0.89, giving it a yield of 3.5%. Consider TD for its reasonable valuation p/e of 11.9, the additional growth Schwab deal brings in the U.S., its strong asset management division, and the possibility of realizing its minority stake in Schwab to increase its capital ratio.

As always, consult with your financial advisor before buying to ensure investments align with your risk-tolerance level and portfolio objectives.

Gavin Graham is Chief Strategy Officer of Calgary-based SmartBe Investments. He is a veteran financial analyst, money manager, and a specialist in international investing, with over 35 years’ experience in global investment management.

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