A warning on Canadian banks

I don`t write about my native Canada very much, but the last few weeks of December is usually a time for getting together with friends and financial professionals. During such occasions, the discussion often turn to the markets.

One of the topics of discussion this year was the outlook for the Canadian market and, in particular, the banking sector. Canadian banks have been a favorite of individual investors in Canada, largely because of their dividend yield and their superior returns in the last few years. In a recent post, local fund manager Tom Bradley of Steadyhand Funds wrote about the growing level of investor complacency in this sector:

I’m slow getting to this, but in the Report on Business a while ago John Heinzl addressed a common question from Canadian investors – ‘Why don’t I just have an all-bank portfolio?’

The question is not a surprising one given how profitable our banks are, what a powerful presence they have in our economy and how well their stocks have done. And it’s timely given questions about the impact a toppy housing market and troubled energy sector will have on the banks’ future. In his piece, however, John suggests that an all-bank portfolio is not a good idea. I concur.

Bradley went on to outline a number of risks facing the banks, including macro risks:

The Big 5 in Canada all have slightly different strategies, but they’re still tightly linked to the same economic factors: jobs, debt levels, commodity prices and the housing market. They will react similarly at times of stress.

From a big picture macro perspective, I would tend to agree. As the black line in the chart below shows, the Canadian financial sector has been beating the TSX Composite for about three years. However, there are a number of ominous signs suggesting that era of superior returns may be coming to an end.

In the above chart, I show a couple of other factors that are correlated with the relative market performance of financials. Credit, as measured by the relative price performance of Canadian corporate bonds (shown in blue), has been on an upswing - until recently. The recent negative performance of credit will likely create stresses in the banking system.

As well, we have seen the value/growth cycle in Canada (in purple) correlate well with the relative performance of financials. In 2014, value has rolled over against growth, which is another potential negative for financial stocks.

While I recognize that correlation is not causation, but these correlations are fundamentally driven. The macro factors that were once tailwinds for the outperformance of the financial sector, which is dominated by the Canadian banks, are now turning into headwinds.

Don't say that you weren't warned.