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Bank downgrades a sign of the coming times

Over the past two decades, betting against Canadian banks stocks has been a suicidal investment strategy. Monday's downgrades by Moody's signal a new longer-term economic backdrop less amenable to outsized bank profit growth.

The Globe and Maiil's Sean Silcoff is completely accurate in his assessment that in the short term, lowering the banks' credit ratings will have next to no impact on investors. It is also true, however, that the secular trends underlying long-term bank profits have run their course

Of the three biggest economic factors driving bank profits – interest rates, demographics and deregulation – the secular decline in interest rates has been the most powerful. After the early 1990s bloodletting in Canadian real estate markets, the decline in rates led to a 20-year, credit-driven expansion in the domestic economy, much to the benefit of the major banks.

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They responded to the adverse effects of the lower-rate environment by simply buying the businesses that benefited. When lower rates pushed investors out of GICs and into mutual funds, for instance, the banks merely bought the major brokerages where the mutual fund assets were being housed. For a while, independent mutual fund companies continued to generate outsized profits, but the major banks have now successfully leveraged their branch networks to dominate sales growth in this area too.

Secondly, demographic factors played a role in pushing the S&P/TSX Bank Index higher by 605 per cent (not including dividends) between 1995 and the end of 2012. The boomers moved into their peak earning and consumption years, creating a virtuous cycle of wealth using mortgage, credit card and other forms of bank-provided debt.

And thirdly, profit growth for Canadian banks was assisted by the legislative dismantling of the four pillars of Canadian finance: banks, trust companies, insurance companies and investment dealers. Deregulation led to the continuing bank incursion into trust company functions and insurance, areas that were previously off-limits.

The outlook for domestic bank stocks is now far murkier for the simple reason that the three trends listed above are over. At 1 per cent, the Bank of Canada rate has little room to fall and indeed Governor Mark Carney continues to signal the likelihood of higher rates as soon as economic conditions warrant. The average Canadian household is already beset with record levels of debt, and rising interest rates will undoubtedly result in a sharp decline in credit growth and bank balance sheets.

The demographic factors that helped drive credit growth, the economy and the housing market are set to move into reverse. As the boomers retire, overall spending and investment will decrease and, barring a large increase in immigration, the necessity for increased housing supply will also fall. Investment with bank-owned brokerages will likely fall as retirees begin withdrawing funds rather than adding to RRSPs.

The major banks will continue to gain market share in insurance and wealth management services but the obvious, most profitable areas for expansion are likely exhausted.

The Big Five Canadian banks will continue to play a central role in the country's economy. Fee gouging can maddening at times for consumers, but the organization and regulation of the banks remains the envy of much of the world and programs like CMHC will protect against major credit upheaval.

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Still, the banks' bulletproof, guaranteed sources of profit and growth are extinguished. Moody's may have done investors a favour in signalling the change.

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About the Author
Market Strategist

Scott Barlow is The Globe's in-house market strategist. He is a 20-year veteran of Canadian investment banks, including Merrill Lynch Canada, CIBC Wood Gundy and Macquarie Private Wealth (MPW). He was a highly ranked mutual fund analyst for 10 years and then, most recently, the head of a financial adviser support team at MPW. More


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