CIO gives his outlook for Canadian financials and explains why he sees the big 4 lifecos as a potential driver of returns
With rate cuts still predicted to come later this year, the skies look a little bit brighter for Canadian financial institutions. Net interest margins and net interest income are predicted to rise somewhat towards the end of 2024. As the year progresses, some analysts think that the fears that held back Canadian financial institutions in 2023 — namely the risk of mortgage defaults and the chance of contagion spreading from the small US financial crisis in spring — should dissipate. In that context, the financial institutions that Canadian investors love so much, may be set for a stronger 2024.
Elliot Johnson, CIO & COO at Evolve ETFs, believes that within investors’ Canadian financials exposure, they should consider a position in Canadian lifecos. Namely the ‘big four’ lifecos of Manulife, Power Corporation of Canada, Sun Life, and Great-West Lifeco. Like their ‘big six’ bank counterparts, these companies have scale, but they also have differentiated drivers that may help investors if Canada does enter a recession this year.
“I don’t know if it’s all that well known, but Manulife, Great-West Life, and Sun Life have larger market caps than National Bank. If they were banks, they would be in that top tier,” says Johnson. “The big six dominate mind space in Canada for good reason, but the key difference is that the lifecos are not susceptible to loan losses. If we do get a recession then banks have more than adequate reserves to deal with their loan losses, but they’re not going to have the best earnings as they work through that. Lifecos don’t have that problem, so they’re much more recession resilient.”
As lifecos’ businesses are built more clearly around insurance, they don’t have the same correlation to losses during a recessionary period. Johnson also notes that they can increase premiums in an inflationary environment as well. While they have similar drivers to the overall financial sector, he sees the key distinction around recession risk as a reason to consider lifecos as a diversifier against the banks.
That is not to say Johnson thinks the banks will fare poorly this year. He’s constructive on financials as a whole. He agrees that the decision by some Canadian banks and lifecos to pursue layoffs in Q4 of last year helped set them up for stronger performance this year. He notes, too, that these institutions have been quite clear about cost controls in their forward guidance for 2024.
There are still unknowns for the financial sector, Johnson says. While investors and analysts are confident about rate cuts, we don’t know for sure if and when they’re coming. The timing of that path to a lower rate will be key, as more and more Canadians come up for mortgage renewals under these higher rates every day. Equity markets have priced in the likelihood of the first cuts coming in the first half of this year, but Johnson notes that there is a risk in the BoC bucking those expectations and delaying cuts.
Because Canadian financials are so concentrated — even if we include the lifecos — Johnson is looking at each company individually to get a sense of where the sector may be headed. That includes the shape of RBC’s acquisition of HSBC Canada as well as TD’s integration of the US investment bank Cowan, which it acquired last year. Johnson believes the macro outlook will only take you so far in such a concentrated sector, so these apparently idiosyncratic stories must be taken into account when investors seek to understand where the sector is set to go.
Within the broader sector, Johnson does see lifecos as still somewhat underrepresented in Canadian investors’ portfolios. Some of that, he says, is due to the huge psychological shadow cast by the big six banks. Some of that also comes down to an understanding of how these businesses operate. Banks are somewhat easier to understand than lifecos and pull in more investor interest accordingly. As advisors consider more lifeco exposure for their clients, Johnson thinks they should work to educate clients on the nature of these companies.
“Clients probably already have an allocation to the banks, but if they don’t have the lifecos I think they need to understand and appreciate the diversifying benefit of lifecos,” Johnson says. “Appreciate that these are blue chip, well run, large established companies that are a good addition to a portfolio that may be overweight banks.”
