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Mar 27, 2019

Sell the Big Six: Analyst warns on banks, says shares could fall 20%

BMO joins rest of Canada's big banks on Veritas' 'sell' list

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A Bay Street bear on Canada’s banks says it’s time for investors to sell all of the Big Six lenders on an expectation credit losses will pile up and potentially trigger a sharp drop in share prices.

“We expect credit losses to move higher by 60 per cent  … through the year and to be back-half loaded,” Veritas Investment Research financial services analyst Nigel D’Souza told BNN Bloomberg in an interview Tuesday.

“In 2015-16, when we last had an acceleration of credit losses, we saw 30 per cent multiple contraction. This time it could be equal or worse, but we expect share price pressure to be in the order of 10-20 per cent, maybe greater, for the sector this year.”

D’Souza downgraded Bank of Montreal on Tuesday, meaning he now has sell recommendations on each of the country’s largest lenders.

“We caution that the sector is likely facing an inflection point in the credit cycle, and that investors should reduce exposure to Canadian banks ahead of an acceleration of credit losses,” D’Souza wrote in a note to clients.

The bear case on Canada's big banks

The Canadian banking sector stumbled out of the gate in the first quarter, with weakness cropping up across the sector. For more on this and the bear case on the banks, BNN Bloomberg spoke with Nigel D'Souza, investment analyst of financial services at Veritas Investment Research.

D’Souza told BNN Bloomberg that BMO’s fundamentals made it the final big Canadian bank to hold out on the firm’s buy side, but that the stock is currently trading at a premium.

“We initially had BMO as a buy and we have a favourable view of the underlying businesses at BMO,” he said. “It’s just really a function of the stock having run up and BMO trading at a premium to its historical valuation that has led us to downgrade the stock in light of our expectations for slowing economic growth and higher credit losses through this year.”

However, D’Souza said his call to sell Canada’s big banks differs from similar bets – often dubbed The Great White Short – by some U.S. hedge fund managers.

For instance, Steve Eisman, a portfolio manager at Neuberger Berman – and best known for his successful bet against the U.S. housing market in the book and film The Big Short – recently took aim at Canada’s banks. Last week, Eisman told the Financial Times he believes Canada’s lenders will be hurt by a struggling economy and weakening housing market.

And earlier this year, a top-performing U.S. hedge fund shorted Canada’s banks based on its view that the Canadian economy is headed for a major recession and that the banks would be the ones to suffer when that happens.

“I think the U.S. hedge fund perspective on the Canadian financial sector – the bear thesis –  has really been driven by the same thesis for the last five or seven years, really borne out of the financial crisis,” D’Souza said.

“I think our thesis is differentiated because we have a specific mechanism where we predict the credit loss cycle accelerating. So whether someone wants to play that as a short or to underweight depends on their investment mandate or their risk profile.”



In his report, D’Souza argued mounting provisions for credit losses in the group’s fiscal first quarter likely wasn’t a one-time phenomenon.

“While some market participants may view elevated credit risk in Q1-F19 as a product of idiosyncratic and non-recurring factors, we argue that the quarter likely marks an inflection point in the credit cycle,” he wrote.

As long as Canada’s household debt problem persists, D’Souza argued investors would be well-advised to lighten up on the banks.  

“Our concern rests more in domestic consumer lending as rising debt service costs, combined with a softening real estate market and more restrictive regulatory measures, continue to stress Canadian households,” he wrote.

“We note that delinquency rates, among banks that disclose retail delinquencies, moved higher sequentially across all retail loan categories including mortgages, personal loans, credit cards and secured or unsecured lines of credits.”

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