Are Canadian Banks Poised for a Breakout Year?

Key Takeaways

• Through the BMO Canadian Banks ETF Fund, investors gain diversified exposure to Canadian lenders that are currently trading at attractive valuations
• Stable economic conditions combined with expectations for benchmark interest rates to fall position banks to outperform other sectors and the broader index
• For investors prioritizing income, or foresee volatility persisting, the BMO Covered Call Canadian Banks ETF Fund provides reliable cash flow while mitigating market swings

It was a challenging year for banks in 2023. What is your assessment of the sector’s performance and how investors responded?

CH For most of last year it was pretty challenging for the Canadian banks, no doubt. Until about October they underperformed the index. The flipside of that however was that investors got higher dividend yields, and that weakness created an opportunity to gain or add to an exposure at an attractive valuation. The big story now is the comeback, with Financials playing catch up with the broader index. Our expectations is that compared to the last couple of years, this is going to be a pretty good one for Canadian banks, and by extension a fund such as the BMO Canadian Banks ETF Fund.

The last earnings cycle started off wobbly, with the Bank of Nova Scotia. They are rolling out a new strategy with their new CEO. But after that, the banks were pretty resilient. The big theme coming into the first quarter of 2024 is that the challenges are manageable. A combination of expectations for rate normalization, positive fourth-quarter commentary and overall performance has helped improve sentiment. We see that continuing this year, aided by a market that is adjusting expectations for a softer landing for the economy. The shift has helped all equities escape the doldrums we were in, but especially Canadian banks.

Would you explain why sentiment as well as expectations for a better 2024 are rising?

CH Absolutely. Financials are more cyclical than other sectors and benefit from a better economic backdrop more than the broader market. It is also extremely rare for Canadian Financials to underperform the index two years in a row. All in all, they are due for a turnaround.

There are lingering economic concerns—the housing market is always top of mind for many Canadians. But if you look under the hood, there is not a lot of real risk there, even on mortgages with higher loan-to-value ratios. Our view is residential risks are not significant.

The commercial loan book is always something we monitor as well as general credit conditions for commercial banking. The banks have been proactive in taking loan-loss provisions and that too is expected to ease going forward. Often, buying the banks when those loan provisions are peaking—which arguably, they are doing right now—can be advantageous from a timing point of view.

Expectations are high that central banks will begin cutting interest rates sometime in early to mid-2024. Is that your expectation and what will that mean for Canadian banks?

CH Markets are pricing in rate cuts from both the Fed and the Bank of Canada (BoC) on the order of one to one-and-a-half percentage points by the end of the year. Fed Chairman Jerome Powell has clearly indicated we are likely to see rate cuts this year.

That certainly helps businesses and individual borrowers. Powell has noted U.S. inflation is easing from the highs, while in Canada, the Consumer Price Index is sitting at around 3%. To continue with a 5% benchmark rate is probably too punishing. There is room for that to come down and still be somewhat restrictive against inflation.

Rate cuts are positive for banks at a time when valuations are still very attractive. It is not as though valuations are stretched and a potential slowdown could trigger a steep decline. The Canadian banks, as a group, are trading at roughly 10 times forward earnings, which is very reasonable. The dividend yield on the BMO Canadian Banks ETF Fund is around 4.75%¹, which is an appealing level as well. Financials are dependent on the economic trajectory, of course, but that looks poised to remain solid this year, while we are starting out at a pretty good entry point for investors.

Which bank should an investor buy or are there benefits to owning a sector exposure via the BMO Canadian Banks ETF Fund compared to owning a single stock?

CH There are merits to a sector approach. To start, it’s a diversified exposure. The group as a whole possesses a strong track record in terms of performance and dividend growth. The fund also handles any rebalancing for you. An investor can efficiently gain that professional management in a very low-cost fund. A client knows exactly what they are getting: an equal weighting across the “Big Six” Canadian banks, which are Royal Bank of Canada, Bank of Montreal, TD Bank, Canadian Imperial Bank of Commerce, Bank of Nova Scotia and National Bank.

As a whole, we view them as a core equity exposure to a stable and typically well-performing sector of the market, and at a very competitive management expense ratio (MER) of 0.28% (F Series).

Let’s shift focus to the BMO Covered Call Canadian Banks ETF Fund which gives an investor the same exposure yet has an options overlay that generates some incremental income. Would you elaborate on the benefits of the strategy and what kind of client it is suitable for?

CH The BMO Covered Call Canadian Banks ETF Fund is definitely designed for income investors. The covered call strategy boosts the annual distribution yield to over 7%¹. It also helps mitigate some volatility because of that income stream, so it is suitable for an investor who thinks stocks broadly, or Canadian banks specifically, may trade in a more rangebound pattern over the next while. One nice thing about the covered calls that I like is taking advantage of volatility. Usually, volatility is a bad thing with equities because when volatility goes up, equities go down. At least with a covered call, you're selling options on that volatility, and turning those ups and downs into an extra source of return. There's still likely to be some additional bouts of volatility in this market and covered call investors can potentially use that to their advantage.

And similar to the BMO Canadian Banks ETF Fund, an investor is accessing a precise exposure overlayed with a sophisticated income strategy at a very reasonable cost of 0.73% MER (F Series).

Fund Performance (%)	YTD	1-Year	3-Year	5 -Year	Since Inception	Inception Date
BMO Canadian Banks ETF Fund - Series F	10.64	10.64	-	-	-0.64	29-May-22
BMO Covered Call Canadian Banks ETF Fund - Series F	6.71	6.71	7.38	7.49	7.49	27-Apr-16

BMO’s Enhanced Dividend Strategies including the covered call funds have become very popular with many investors in the past few years. Why do you think that is?

CH Canadian investors love income and who doesn’t? But Canadian investors tend to gravitate toward reliable dividend stocks and that certainly characterizes the Big Six banks which consistently grow their quarterly and annual payouts.

When inflation was high and Canadian investors were looking at investment tools to keep up with rising prices, covered calls were great tools to do just that. The distribution rates were in the 6-8% range, generally speaking, so we did see a lot of flows over the past couple of years as inflation was elevated. Going forward, with many investors now holding an exposure to a covered call fund, there is an appreciation and preference for the income coming from blue chip dividend paying stocks, which is what our lineup of covered call funds tends to focus on—and banks, obviously, are a perfect example of that.

We sometimes ask the people we interview about a book or podcast they’ve read or listened to that provided an insight about investing and approach to financial management. Is there a title you’d like to share?

CH This one is a little out there, but I recently read a biography about the German classical composer, Johannes Brahms. It was interesting to get all the context around how his career developed. One thing I realized was beyond being a very good composer he was equally, if not more so, crafty. He nurtured key relationships that could aid him in marketing his music. He became very good friends with a big Vienna music critic at the time as well as other wealthy benefactors. So, he was actually one of the first kind of really profitable musicians in the way we might understand famous musicians today. Other bigger names, like Beethoven or Mozart, died with not a lot to their name. Brahms ended up quite well off and effectively was the ‘first’ really wealthy musician.

BMO Canadian Banks ETF Fund

FundSERV Codes	Front End8	MER(%)
Advisor	BMO99262	1.41
T6	BMO34262	1.41
F (Fee-Based)	BMO952628	0.28
F6	BMO36262	0.27

BMO Covered Call Canadian Banks ETF Fund

FundSERV Codes	Front End8	MER(%)
Advisor	BMO99765	1.64
F (Fee-Based)	BMO957658	0.73
F (Client Name)	BMO68765	0.73