Oil’s plunge and GDP fears put banks on slippery slope

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Canadian economic concerns and a devastating drop in oil prices are weighing on sentiment toward bank stocks: Share prices are down sharply and one analyst is now raising eyebrows with a downward shift in his outlook for the sector.

"Despite recent weakness in the performance of the Canadian banks, we see little additional upside potential and believe that slower-than-anticipated economic growth will weigh on the earnings growth and valuations of the group," said John Aiken, an analyst at Barclays Capital, in a research note.

His outlook follows the weakest performance in Canadian bank stocks since global stock markets were rattled in 2011 over Europe's sovereign debt crisis. The S&P/TSX bank industry group has fallen 14.7 per cent from its record high in September, putting it deep into correction territory.

On Friday, the index fell 2.9 per cent, its worst one-day decline in more than three years.

The months-long downturn comes as a number of observers ponder the economic ramifications of crude oil prices, which have tumbled more than 50 per cent since the summer, despite a rebound on Friday to $47.76 (U.S.) a barrel, up 7.3 per cent.

Statistics Canada appeared to confirm the concerns: It reported that Canada's gross domestic product contracted by 0.2 per cent in November, month-over-month, missing economists' forecasts.

"Over all, it seems that the collapse in oil prices is already beginning to dampen economic activity," said David Madani, Canada economist at Capital Economics, in a note.

The Bank of Canada lowered its key interest rate last week, to 0.75 per cent, in an attempt to spur economic activity. The surprise cut formed part of Mr. Aiken's outlook on Canadian banks.

"From our standpoint, the surprise reduction in the overnight rate by the Bank of Canada is a net negative for the banks," he said in his note.

"We believe that the action from the central bank implies lower economic growth than is currently reflected in the market. Further, we do not anticipate a significant uptick in consumer loan demand and believe that incremental margin compression is likely."

He downgraded his recommendation on Bank of Montreal, Laurentian Bank of Canada, Royal Bank of Canada and Toronto-Dominion Bank to "underweight" from "equal weight" – which is essentially a recommendation to sell the stocks. The shift makes him the only analyst with a sell recommendation on Royal Bank since April, 2013.

He is maintaining lukewarm "equal weight" recommendations on Bank of Nova Scotia, Canadian Western Bank and National Bank of Canada. He also maintained an "underweight" recommendation on Canadian Imperial Bank of Commerce.

He concedes in his note that his pessimistic view on the banks is "out-of-consensus" and that investors avoiding the banks would obviously miss out on any rebound. He added that strong dividend yields should provide support for the stocks.

However, he argued that earnings expectations are likely to fall in the near term.

"Currently, our downward revisions put estimates modestly below consensus earnings estimates [approximately 2 per cent], but our targets are roughly 8-per-cent lower on average," he said.

The banks will start to roll out their first-quarter results in late February.