Managing partner of asset manager explains why layoffs are part of normal "clean up quarter" in Canadian financials
Large-scale layoffs at Scotiabank and Desjardins hit the news this week, following expense management noise and headcount cuts from other major banks earlier in the year. The sector is cutting in a tough operating environment. The Canadian economy appears to be weakening, punishing bank revenues and loan growth. At the same time the inflationary environment has pushed expenses higher. The picture doesn’t look rosy, yet one financial sector expert sees the potential for a strong 2024 in these announcements.
Robert Wessel, managing partner at Hamilton ETFs, explained that Q4 is often treated as a “clean-up quarter” by the banks during difficult operating environments. In a recently-published note, Hamilton — the second-largest manager of Canadian bank ETFs by AUM — outlined the options banks might employ: they can accelerate their loan loss reserves, write-down or sell assets, and/or book restructuring charges to reduce forward run-rate expenses.
“The Scotia result was very close to what we predicted in a note we wrote about the sector last month,” Wessel says. “Write-downs and restructuring charges – including severance – pulls forward expenses into Q4, and lowers run-rate expenses in future periods, primarily compensation. This also provides a favourable comparison in future years and increases EPS growth. Basically the banks are trying to clear the decks for next year”
Wessel cites a CIBC bank analyst reaction to the Scotiabank layoffs suggesting they might increase forward earnings for the bank by over 3.5%.
While he says these banks face a challenging environment, in part due to rising deposit costs, we aren’t seen the kind of crisis in confidence that impacted some regional US banks in March. We also aren't seeing the kind of tailwinds from interest income that some major US banks reported in Q3. While analogies to US performance can be helpful, Wessel notes that Canadian banks don’t have the same volatility in net interest income as their US counterparts. He thinks Canadian financials should be viewed more as a financial conglomerate than a traditional commercial bank.
Wessel is optimistic about Canadian financials in 2024 but says their earnings reports this quarter will give investors a clearer picture.
“It could be that the worse Q4 is, the better the next year will be,” Wessel says. “We’re interested to see if Scotia is a one-off — which we don’t think it is. We think everybody is going through this process and we would be very surprised if there aren’t more restructuring charges…We’ve seen this movie before.”
Beyond just their earnings, Wessel believes the economic outlook will be key determinants in their 2024 performance. A range of unknowns could still impact his outlook, such as regulatory changes or monetary policy. Nevertheless, Wessel thinks history is on the banks’ side right now.
Canadian banks posted a negative total return over 24 months at the end of August. According to Hamilton, that has only occurred 22 times in the 232 month-ends over the past 20+ years. Moreover, after posting negative two-year returns historically, Canadian banks have delivered a positive return in the following twelve months 21 times.
Wessel believes that absorbing bad news in Q4 reporting could support forward earnings estimates which would support valuations for Canadian banks, allowing them to start to show positive returns again. In this environment, Wessel believes that Canadian advisors’ longstanding faith in the banks may be rewarded.
“Advisors have had a very good experience with Canadian banks and a lot of confidence in the sector,” Wessel says. “I would emphasize that dividends are almost certainly rock solid at about 5.5% yield so you’re getting paid to wait. A lot of bad news has been taken on already, so valuations are extremely low. If I was an advisor, I wouldn’t tell anybody to underweight the sector or stay away. I think that history has shown time and time again that when the banks are at less than 9x earnings, that’s been a very good entry point.”
