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After two years of robust earnings growth, Canadian banks are bracing for a period of softening and a potential recession.

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While share prices in the banking sector already reflect the expected earnings slowdown in 2023, Natalie Taylor, portfolio manager at CIBC Asset Management, said there are several factors that could impact earnings.

Banks with strong capital levels, attractive valuations and healthy dividend yields such as RBC and TD remain appealing in this environment, Taylor said. However, she believes there are few opportunities in high-quality defensive companies with long-term growth potential.

“While banks have a well-earned reputation for being consistent performers, there’s no doubt that they are economically sensitive,” she said.

Banks’ earnings shortfall in the second quarter was primarily driven by increased margin pressure and higher expenses, Taylor said, which rose by an average of 11%. She attributed this rise to the higher inflationary environment and an increase in credit costs.

While Taylor warned that earnings are expected to continue declining modestly for the remainder of the year, “a number of wild cards” could impact that forecast.

First, she pointed to the trajectory of expenses and whether management teams become more aggressive in managing them. Second, the potential growth uplift from rising immigration could bring in new customers to the banks.

Finally, Taylor mentioned the Bank of Canada’s surprise interest rate hike in June, signalling a more hawkish stance than expected.

“The chance of a policy error or the perception of a policy error increases, and the odds of a recession also continue to increase,” she said.

While a slowdown in economic growth is already reflected in the earnings estimates for Canadian banks, Taylor said a recession is not priced in, and accurately predicting the timing and magnitude remains challenging.

The biggest source of earnings variability for banks during a recession is the increase in credit costs, Taylor said, which can spike to two to three times the current levels.

Previous downturns have led to an average decline of 15% to 20% in bank earnings, she said, compared to the mid-single-digit decline embedded in consensus estimates.

In severe cases where banks are undercapitalized or face substantial credit costs, Taylor said valuation multiples can remain impaired for an extended period, though earnings tend to recover within one to two years.

Taylor noted that Canadian banks have maintained their dividends over the past 30 years, with increases occasionally halted during downturns but rates not cut.

Taylor sees opportunity in a couple of financial companies that have faced near-term setbacks, creating a buying opportunity.

Element Fleet Management, which offers financing and services related to corporate fleets, is the largest standalone player in a growing and consolidating industry, she said. And Intact Financial, the country’s largest property and casualty insurer, will also benefit from its scale.