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McMurtry Investment Report Newsletter – April 2019

April 2019 – What to do with Financial Stocks

The financial sector remains the largest component of the TSX Composite Index at 31.70%. US Financials represent the third largest equity sector of the S&P 500 at 12.7%. For my North American sector weights, I continue to advise 55% in the US and 45% in Canada. This works out to be 21.25% of the total equity North American component, the single largest group on a weighted basis.


Historically the Canadian banks have been more consistent performers over time with considerably less risk than their US counterparts. During the last recession of 2008 no Canadian bank cut its dividend, but in the US it was a completely different situation. In order to avoid a total financial meltdown, the stronger US banks were forced by the US Government to acquire their weaker competitors. In that venue Bank of America bought Merrill Lynch to avoid a bankruptcy of the latter company. JP Morgan, the best capitalized US bank was also required to acquire financial institutions that were on the verge of collapse. The term “ Too Big to Fail “ was coined at that time.


Canadian banks were much better capitalized during the last recession and their coast to coast branch network system allowed them to access funds more cheaply without disrupting their overall domestic financial condition. While loan losses rose considerably for the Canadian banks, they paled in comparison to their US peers.


Canadian banks have much less competition and are considered oligopolies. There are many US banks that are not well capitalized where the competition is much more intense than in Canada.


Domestically, any type of criticism of Canadian banks from a shareholder point of view is usually brushed off. For example, a US hedge fund manager has been recommending shorting Canadian banks and the investor reaction to this has been to largely ignore this advice.


Despite the relative advantages of Canadian banks over US ones, it is still essential to determine if North American banks represent good investments at this time.


Banking has different divisions that do not all perform in the same manner. Consumer banking, the largest component, is greatly affected by the level and direction of interest rates in addition to any federal or state regulatory changes to mortgage eligibility rules. Commercial banking is not only affected by interest rates but also influenced by the state of the domestic and global economies and by the level of corporate tax rates. Both consumer and commercial banking are heavily influenced by the shape of the yield curve or the spread between short and longer maturities. Investment banking and trading is affected by many factors including interest rates, global and domestic growth and the financial health of the corporate sector. Finally, wealth management, the fastest growing division, is heavily influenced by the stock and bond market performance.


Life insurance companies are not affected nearly as much by the shape of the yield curve, but are much more influenced by the direction of interest rates – the higher the better. This is because their long-term liabilities on the balance sheet are discounted back to the present value at a lower valuation when rates rise. For property and casualty insurance companies their liabilities are much shorter term in nature and consequently are not nearly as negatively affected from falling rates as life companies are.

Current Outlook

The recent inversion of the yield curve globally with short rates climbing above long rates has triggered a warning signal. In the past, all recessions experienced a negative or inverted yield curve 6-18 months in advance of an economic slowdown. Last week the yield curve in the US and Canada inverted, but it has since flattened out. However in Europe, the yield curve remains inverted. The yield curve is suggesting that economic growth both domestically and globally is slowing. This can lead to a recession but it does not automatically imply that it will.


The key point to take away from this discussion is that the US Federal Reserve has stopped raising rates for the remainder of this year. Larry Kudlow, President Trump’s economic adviser, suggested last week that The Federal Reserve should actually lower rates immediately. The Fed did not take Kudlow’s advice but if it did the equity markets would respond favourably on the upside.


Stable to falling rates is not beneficial to bank interest rate spreads. An inverted or flat yield curve is also not beneficial to bank operating margins.


Weakening domestic and global economic growth is not beneficial for bank profitability. Historically in a period of lower economic growth loan losses begin to rise sharply. In Canada we have the double whammy of an overextended consumer who is vulnerable to any weakness in the domestic economy. Canadian consumer debt as a percentage of disposable income has reached record levels.


We need to keep in mind that bank stocks are cyclical and their profitability goes up and down with overall economic growth. Many investors do not think that bank shares are risky at all. This is a complete fallacy!


During the last recession of 2008 bank shares in both Canada and the US did not perform very well. While the absolute percentage price change for the S&P 500 and the TSX Composite in 2008 was down 39% and 35% respectively, RBC and TD were both down close to 60% over this period. Bank of America shares were down 63% wile Citibank’s fell by almost 76%. Only JP Morgan outperformed the index by falling only 25%. It is obviously very clear from these numbers that banks do not perform well in a recession.


The combination of lower interest rate spreads, the expectation of rising loan losses and weak and highly unpredictable investment banking do not bode well for overall profitability. Wealth management’s profits should rebound this year with the rising security markets we have experienced year to date. However, should markets fall once again profits from wealth management will turn down.


Taking into account all these negative headwinds, I am advising a reduction in overall sector weight from overweight to market weight. As indicated earlier, my North American benchmark financial sector equity weight for April is 21.25%. Should economic growth continue to weaken, I will not hesitate to go underweight this sector.


Peter McMurtry, BCom, CFA
Financial Writer
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