March 4, 2012 / 5:18 PM / 6 years ago

At Canada's banks, the problems are all relative

TORONTO (Reuters) - Canada’s rock-solid banks may be facing a gloomy profit outlook, but it’s one that most of their U.S. and European rivals would jump at in a Wall Street minute.

With low interest rates squeezing lending margins and heavily indebted Canadian consumers expected to curb borrowing, executives and analysts say the banks now face a shrinking upside after posting record earnings from domestic operations for their financial first quarter.

In other words, their rich profits will keep on growing, just more slowly than in the recent past.

For global rivals that are still struggling to recover from the 2008-09 U.S. mortgage crisis, or are waist-deep in the European sovereign debt mess, the Canadian banks’ problems may seem trivial.

Indeed the Canadian lenders, almost by default, have been left among the strongest in the world after financial crises on both sides of the Atlantic over the past four years have turned the parameters used to evaluate banks almost on their head.

“Slowing earnings growth is probably the best problem to face,” compared with what many U.S. and European banks are looking at, said John Aiken, an analyst at Barclays Capital, and typically one of the most bearish of the analysts that cover the Canadian banks.

However, within the cloistered Canadian industry - the banks are protected from takeover by government regulation and the Big 5 hold nearly immovable double-digit domestic market shares - the lower profit growth is a cause for concern, and among investors it may seem a very real reason to be cautious on the shares.

“You’ve been seeing (profit) growth in the mid teens, and that growth is not sustainable,” said Robert Sedran, an analyst at CIBC World Markets, acknowledging that investors in the sector have been spoiled by steady returns.

“When we’re looking at the (Canadian) banks, people almost treat slowing growth as negative growth.”

MORTGAGES

Analysts have been forecasting a slowdown in Canadian bank profits for more than a year, but with Canadians still eagerly buying houses - spurred by historically low interest rates - a meaningful slowdown is only now starting to show its face.

On conference calls on Thursday to discuss quarterly results at the country’s two largest banks, Royal Bank of Canada RY.TO and Toronto-Dominion Bank TD.TO, executives pointed to low interest rates and early signs of a borrowing slowdown - particularly in lines of credit - as reasons to be cautious.

However, they made these comments after the four banks that have reported quarterly results so far have all beaten analysts’ estimates.

While both TD and Royal showed a slight drop in net profit due to lower capital markets revenue, both reported record profits at their domestic retail bank segments and raised their quarterly dividends, prompting several analysts to raise their share-price targets.

John Kinsey, a portfolio manager at Caldwell Securities and longtime owner of Canadian banks, said he’s not concerned about their profits.

“I think they’re solid if not spectacular. They may have some margin squeezes here and there, but I think they’ll be all right,” he said, adding that he was surprised that Royal and TD boosted their dividends.

“Maybe it was just kind of a token gesture to (show) the shareholders that while everybody’s in pretty bad shape worldwide, for the Canadian banks things are pretty good.”

PROFITS STEADY, BUT STOCKS?

While the profit picture is a question of whether results will be just good instead of great, analysts say the longer-term outlook for the banks’ shares is a legitimate cause for concern.

As the Canadian banks surged during 2009 following the 2008 market crash, they attracted capital from many investors who were abandoning troubled U.S. banks.

With the Canadian banks now trading at healthy stock multiples and the U.S. banks starting to eye a recovery, those flows could soon reverse, particularly if the Canadian banks’ profit gains narrow, Aiken said.

“There are a lot of investors who either have that trade on or are just itching to make that trade, and if we start to see core earnings growth in the U.S. banks start to rebound... then you could see people selling the Canadian banks to switch,” he said.

Sedran said the issue is one of the Canadian banks having outperformed for several years on the back of a cycle of increased leveraging of the Canadian consumer, and that cycle appears to be at an end.

However, he notes the banks have sources to offset the consumer lending slowdown, such as business lending portfolios that are sure to rebound, as well as wealth management businesses and international operations that would benefit from an economic rebound.

“You’ve got to be careful getting too negative on the Canadian banks because they do have resilient cash flow streams, they do have resilient businesses and they do have leverage at their disposal to offset some short-term weakness,” Sedran said.

Reporting By Cameron French; Editing by Peter Galloway

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