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Banking sector worries ease ahead of Q1 results, but relief still a ways off

Canadian banks are gearing up for their first-quarter earnings, and despite the international stock markets hitting record highs, the banking sector in Canada is facing some challenges that have tempered investor enthusiasm.

Concerns surrounding slow loan growth, risks associated with existing loan portfolios, and various headwinds like alterations to tax exemptions and capital requirements have kept Canadian bank shares from gaining substantial momentum. However, there's a glimmer of relief as some of the major worries seem to be subsiding, according to Scotiabank analyst Meny Grauman.

After enduring several quarters of pessimism, analysts are becoming cautiously optimistic about the outlook for Canadian banks. Grauman notes, "The only hitch is that from a numbers point of view, we only see that happening in (fiscal) 2025."

One of the primary factors impacting the sector is slow loan growth, particularly in the U.S. Additionally, the removal of a tax deduction on dividend income from Canadian businesses is expected to weigh on the results for this year. Grauman anticipates that first-quarter earnings could be six percent higher than the last quarter but approximately 11 percent lower than the same quarter in the previous year.

Carl De Souza, sector lead of North American financial institutions at Morningstar DBRS, highlights that banks will likely be affected by the continued setting aside of funds for potentially bad loans as part of the ongoing credit normalization process. The commercial real estate sector, especially in the U.S. office market, is posing challenges, but Canadian banks, due to their diversified nature, are expected to weather through.

National Bank analyst Gabriel Dechaine provides some reassurance, stating, "Aside from a few pockets of weakness (e.g., commercial real estate), the credit picture has been a benign one."

Looking ahead, Dechaine expects to witness significant improvement in expenses throughout the year, following last year's substantial charges related to layoffs. However, the benefits may not be immediately evident in the first quarter, with a more noticeable impact in later quarters.

The margins banks make on interest are anticipated to expand, but this improvement is likely to be seen in the latter half of the year, according to Dechaine. The delayed positive developments, combined with cautious management commentary, have contributed to the underperformance of the Big Six bank stocks compared to the market in early 2024.

Amidst the concerns in the banking sector, the broader economic picture in Canada is showing signs of improvement. A slowdown in the inflation rate, resilient housing market, increased home sales, and a decline in the unemployment rate to 5.7 percent are contributing to a more positive economic outlook.

Grauman expresses confidence in the resilience of the Canadian housing market, even in the face of an upcoming mortgage renewal wave. Despite the positive economic data, James Shanahan, senior equity research analyst at Edward Jones, suggests that the quarter's expectations are low. He sees potential upside in capital markets activity, particularly in initial public offerings and mergers and acquisitions, as a strong catalyst for earnings growth for Canadian banks.

The upcoming earnings reports from Scotiabank and BMO on Tuesday, followed by RBC and National Bank on Wednesday, and CIBC and TD Bank on Thursday, will provide a clearer picture of the Canadian banking sector's health and its ability to navigate the current challenges.

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