Easing rates spur bank sector

National Bank to acquire Canadian Western Bank

Interest rate proxies have suffered from worries over the effects of higher interest rates on their borrowings, even though most of their debt is long-term and fixed-rate. These include banks, as well as other sectors regarded as being sensitive to higher interest rates – usually those with a high debt load like utilities, pipelines, telecoms, and REITs.

The banking sector has been a major laggard against the broader stock market indexes over the last two years since the Bank of Canada, along with other central banks, began aggressively raising interest rates to tackle 40-year highs in CPI inflation.

For banks especially, higher bad debts leading to big increases in provisions for credit losses (PCLs) have been a major negative factor. This has offset the benefits of higher net interest margins (NIMs) between their borrowing costs (the rate they pay on deposits) and lending costs (what they charge borrowers like you and me).

The case for buying banks (and other interest rate sensitive sectors like utilities and REITs) was based on the likelihood that the price declines caused by rising interest rates that led to their underperformance would reverse course once interest rates began to fall.

In fact, as rates peaked in mid-2023 at 5% in Canada and 5.25%-5.5% in the U.S., the banking sector started to move up. Over the last 12 months, the iShares S&P/TSX Financials ETF (TSX: XFN) is up 11. 4%, outperforming the broader S&P/TSX 60 Index, which rose 9.4%. In the U.S., the KBWB Bank ETF (NDQ: KBWB) in the U.S. is up 21.7%. That’s close to the performance of the S&P 500 Index (24.9%).

But the rate cycle appears to have peaked. On June 7, the Bank of Canada became the first of the G-7 central banks to reduce interest rates, cutting its target overnight rate by 25 basis points, to 4.75%. That confirmed a reversal in the interest cycle, with the direction of travel now downwards. The European Central Bank followed suit later that week, reducing interest rates to 3.75% from 4%, although cautioning investors against assuming further cuts would happen in the near future.

With distinct signs of the economy in the U.S. slowing down too, investors believe that the U.S. Federal Reserve will follow suit. However, there is sufficient ambiguity in the various jobs and inflation numbers that the Fed will likely leave cuts until the final quarter of the year, especially with the presidential election campaign in full flow.

While bank share prices have begun to reflect this turn in interest rates, there has been a wide disparity in individual performances. The U.S. money centre banks have continued their strong performance that began with the regional banking crisis that started with the failure of Silicon Valley Bank in March last year. JPMorgan Chase is up 38% in the last year, Bank of America up 33%, Wells Fargo ahead 36%, Goldman Sachs up 32%, and Citigroup ahead 22%.

Canadian bank performance varied

However, the performance of the Canadian banks has been much more varied. Royal Bank of Canada, the nation’s largest bank, extended its market share dominance by buying HSBC’s Canadian operations and saw its share price rise 17%. Hot performer and the fastest-growing chartered bank, National Bank, is up 21%. Steady performer CIBC is up 16%, while former favourite TD Bank, battered by failures in its U.S. money laundering detection systems, is down 5%. Laggard Scotiabank is off 3% and even Bank of Montreal, digesting its major U.S. acquisition of Bank of the West is down 1%.

This outperformance is very likely to continue if previous stock market cycles are any guide. Interest rate cycles have proven to be a very successful method of generating attractive returns. Evidently, bank managements think so too.

National Bank on the acquisition trail

National Bank of Canada (TSX: NA) has chosen to take advantage of the very low valuations caused by the sharp rise in interest rates, making an all-share offer to buy Canadian Western Bank (TSX: CWB) for $5 billion, a 110% premium to CWB’s pre-bid price.

National has been on a tear, up 89%, making it by far the best-performing Canadian chartered bank. CWB, on the other hand, was down almost 20% before dividends over the same period, reflecting the problems of the energy industry in Alberta and Saskatchewan on which much of its business depends.

As a result, National is very logically using its highly valued stock, selling at 1.7 times its book value, to buy CWB’s very cheap stock, selling at 0.63 times book value. Even with the premium it’s paying, National Bank’s acquisition will be immediately accretive to earnings and will raise its return on equity. National expects to save $270 million annually by the third year after the acquisition closes at the end of 2024, through savings on operations and technology systems.

CWB is Canada’s eighth-largest lender, with $37 billion in loans to 65,000 customers. It has 39 branches, of which 16 are in BC and 14 in Alberta. The takeover deal increases National’s lending portfolio outside Quebec by 37%, but BC and Alberta already represent 24% of its assets under administration. It also will grow National’s commercial lending portfolio, folding in $30 billion worth of CWB’s $39 billion in assets in this area, with a special niche in equipment financing and mid-market lending. CWB also had strengths in trust services and wealth management, both areas attractive to National Bank.

Given the large difference between the value of the bid and the current share price of CWB, investors should retain their shares until the deal closes, unless they need the cash for a specific purpose.

Gavin Graham is a veteran financial analyst, money manager, formerly Chief Investment Officer of BMO Financial, and a specialist in international investing, with over 35 years’ experience in global investment management.

Notes and Disclaimer

The commentaries contained herein are provided as a general source of information, and should not be considered as investment advice or an offer or solicitations to buy and/or sell securities. Every effort has been made to ensure accuracy in these commentaries at the time of publication, however, accuracy cannot be guaranteed. Investors are expected to obtain professional investment advice.

The views expressed in this post are those of the author. Equity investments are subject to risk, including risk of loss. No guarantee of performance is made or implied. The foregoing is for general information purposes only. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.

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