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Why this investment firm says the upside for Canadian banks is shrinking

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Canadian bank stocks have made investors a lot of money over the years, but it might be time to cash in.

Canaccord Genuity is advising clients to underweight bank stocks in their portfolios — downgrading them because it expects earnings growth to slow, which would mean disappointing returns for investors.

It says household debt, which continues to hover near record-highs, will put a cap on how much more Canadians can borrow from the banks for mortgages and personal loans. But business activity could also take a bit out of the banks’ bottom line.

“On Canadian banks, our downgrade is not triggered by recession concerns,” Martin Roberge, director of North American portfolio strategy at Canaccord Genuity, said in a research note.

“We are accounting for the fact that business lending is now downshifting at a rapid pace, catching up with the contraction in US C&I (commercial and industrial) loans.”

A backlog of inventory among Canadian companies is also a cause for concern for Roberge. 

“The rapid increase in the inventory-to-shipment ratio in Canada suggests that the rise in banks’ loan loss provisions should continue to increase over the next year,” he said.

Roberge also expects lower interest rates to eat into the banks’ margins.

“We believe that the Bank of Canada will lower interest rates this year, confirming the growth slowdown,” he said.

“Already, the Canadian 10Y/2Y bond yield curve is nearing the lows of August last year. That implies a further compressing in lending margins or NIMs (Net interest margins).”

Another reason bank shares could be set for a fall is valuation, since many of them are more expensive than usual.

“As a reminder, Canadian banks traded as low as 9x forward EPS (earnings per share) when the yield curve inverted last year.”

“At 10.5x forward EPS, there is some room for valuation to contract given the above backdrop.”

Roberge isn’t saying investors should dump bank stocks entirely, but he sees better opportunities in other sectors, like energy.

Already seeing weakness

As a group, the banks have underperformed the TSX over the past 12 months.

The BMO Equal Weight Banks Index ETF (ZEB.TO) is a basket of Canada’s six biggest banks in equal proportions. It contains shares of Royal Bank of Canada (RY.TO), The Toronto-Dominion Bank (TD.TO), Bank of Montreal (BMO.TO), Canadian Imperial Bank of Commerce (CM.TO), The Bank of Nova Scotia (BNS.TO), and National Bank of Canada (NA.TO). 

ZEB.TO vs. the TSX.

Not including dividends, it’s up around 4 per cent compared to around 12 per cent for the broader TSX.

Over the past 2 years that bank ETF from BMO is up around 4 per cent compared to around 14 per cent for the TSX.

Jessy Bains is a senior reporter at Yahoo Finance Canada. Follow him on Twitter @jessysbains.

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