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Developed market banks a 'value trap:' Pimco

Canada's big banks have avoided the train wreck that has swept through much of the world's financial system. This week provided more examples, as the banks reported their results for the latest quarter.

Fred Lum

Banks in the U.S. and Europe may look cheap, but Pimco's value fund is staying away, calling the financial institutions a "value trap."

"In developed market banks we generally do not see meaningful upside potential in equity positions over the secular horizon," Pimco Pathfinder manager Chuck Lahr said in a new commentary.

Mr. Lahr doesn't mention Canadian banks, but some of his concerns apply.

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1. Loan Growth. The first roadblock Mr. Lahr identifies is loan growth. He expects "limited" gains in loan portfolios because consumers are already levered up and economic growth is sagging.

"Many investors may be looking at loan growth as the critical variable needed to drive bank stock prices higher due to a perceived lack of other drivers at this point; credit quality has generally improved and while cost cutting can presumably be done, meaningful earnings growth may be difficult to achieve without loan growth."

How does this apply to Canadian banks? The dynamic is similar. The first Canadian institution to report in this earnings season, HSBC's Canadian arm, said that loan growth has slowed and the company's CEO said loan loss provisions have come down about as far as they can.

2. Balance sheet risk. Mr. Lahr is particularly concerned about risks on the balance sheet of European banks. He's clearly not alone, given the recent turmoil in the European banking sector. For now, Canadian banks seem relatively immunized. They don't hold much direct European sovereign debt.

3. Regulatory risk. "The regulatory environment for banks in developed markets remains harsh," Mr. Lahr said. Canada isn't immune to any of the global requirements for more capital, which make some traditional lending businesses far less economically attractive. However, Canada has not implemented some of the more far-reaching reform attempts, such as the U.S. Dodd-Frank act is doing.

Mr. Lahr's rationale is not a perfect fit for Canadian banks, but there is some overlap.

And there are those who believe that for such reasons, the era of Canadian banks being no-brainers to buy for big long-term gains is over. One is Rob Wessell, a long-term bank analyst who now runs a financials fund, and who recently argued the "golden age for Canadian banks is over."

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Mr. Lahr concedes there may be a "trade" in buying up beaten-down banks, but long-term, he would rather stay away.

"So could there be short-term upside potential in the large-cap bank space in Europe and the U.S.? Perhaps a trade exists, as the group has declined meaningfully this year and sentiment could improve. But longer term for Europe, we feel balance-sheet risk for the banks will persist due to sovereign debt issues. We have a more constructive outlook on the U.S., but believe the headwinds on loan growth, regulation and earnings power previously mentioned still exist and may limit upside."



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