By Ron Friesen
Following the news of Moody’s recently downgrading the credit rating of six of Canada’s big banks we are now in Q2 reporting season for the big five. There is understandable difficulty for many consumers to interpret the news and reports with confidence, especially under exposure to seemingly conflicting views. The credit rating at Canada’s big banks drop amid higher earnings and profits. What? Imagine how investors feel.
The cost of borrowing is going to go up at some point. Of course, I’m relying on the cycles of history for this conclusion. The question here is, what will be the effect on Canada’s population following lower debt ratings of big banks?
BMO just published their Q2 results to April 30, 2017. The report shows continuing higher profits, but rambles into the topic of anticipated increasing debt repayment risk. This seems to support the statement from Moody’s purporting their recent credit rating downgrade is more about Canadian banks facing a more challenging long-term outlook.
Meanwhile, RBC reported an 11% increase in earnings over last year to $1.85 per share, adding its capital business continues strong and healthy.
The concern from Moody’s appears to arise from increasing long-term risk exposure for lenders based on issues of Canada’s housing affordability and high consumer debt-to-earnings ratio. We have seen reports of the household debt in Canada increasing from close to 100% of disposable income in 2001 to over 167% of disposable income at the end of 2016.
It is important consumers understand Canada’s banks continue to be rated near the top of global rankings in terms of being able to meet their financial commitments. The banks’ recent rating downgrade by Moody’s seems more about anticipating the ability of banks to deal with long-term risks and encountering a more challenging environment for financial stability going forward.
Here is what any recognized credit rating downgrade should mean to consumers. When a lender’s credit rating goes down – borrowing rates tend to go up to compensate for increased perceived risk. The effect is amplified when worries are stimulated about lender vulnerability in the face of any downturn in the country’s economy.
But, is it only Moody’s who feels the situation requires a downward rating adjustment? Well…..yes. Here is another aspect of the grading of Canadian banks. There are four credit rating agencies most recognized as influential and who provide investors with note-worthy opinions. In addition to Moody’s there are Standard & Poor’s and Fitch in the United States and Canada’s own Dominion Bond Rating Service (DBRS). Of this group of recognized CRAs, Moody’s and DBRS currently indicate a more negative long-term outlook for Canadian banks while Standard & Poor’s and Fitch see the outlook as stable. But DBRS has not issued a rating downgrade for the banks as Moody’s has.
How do investors decide what to do?
One of the greatest challenges in this day and age of instant access to information is being able to establish the integrity of the information available. So, when Moody’s or any other respected source takes action like changing rating status of any company or government we need to consider what they are seeing, what they are trying to say, and why.
It seems there is agreement about the Canadian banking industry continuing to demonstrate it has a healthy buffer to protect itself from devastating effects caused by en-mass loan defaults. The Moody’s rating downgrade is simply a legitimate indicator and heightens investor awareness, certainly, but Canadian banks continue to enjoy excellent ratings and confidence.
What about consumers, then? How does this news really affect an individual? And why is this important for an investor to consider?
I do not consider it a stretch to suspect individual consumers become more sensitized to their personal financial integrity as national statistics show growing consumer vulnerability. Reports about dangerous levels of borrowing tend to signal responsible consumers to reduce personal debt load. Month-by-month it comes time to reduce outstanding credit card balances, accelerate payments on our mortgages and consumer loans. Barring an increase in our personal earnings, this action will require reducing spending in certain areas of life. We’ll indulge in less entertainment and travel perhaps. Put off the new car purchase a year or two. We might look at a less expensive mobile phone package and fewer cable television channels.
The rating downgrade of some big Canadian banks may not be enough to slow down the greater proportion of consumers, but it may be a little red flag to many, especially as lending rates increase. As other flags begin to flutter about in public, such as rising US interest rates, we may see financial correction from more consumers. Eventually we could see the self-fulfilling prophecy. As consumers spend less to protect themselves from high interest rates and personal financial instability the economy loses steam from lower consumer spending. Jobs are lost and revenues fall. Investors will shuffle money around causing further instability. Sheesh!
It’s the tipping point we need to be concerned about. When the greater proportion of consumers do take action to protect their personal wealth their spending will slow the economy. The first sign of this is usually seen in reduced spontaneous purchases and unplanned spending. Restaurant lunches become simpler and less expensive, saving maybe ten or fifteen dollars a week to start. Then bringing lunch from home. Only ten coffees a week! Suddenly through the magic of the scale of economy we see hundreds of thousands of dollars slip away from the economy, five dollars at a time.
Think conservatively about just fifty thousand consumers in the Greater Vancouver area, or any Canadian city or jurisdiction really, each saving just ten dollars a week to help reduce their credit card balance each month. There it is…over two million dollars a month out of the local small business earnings, just in lunches and coffees. It would have an effect.
Again, there is nothing in the small change to Moody’s credit rating for Canadian banks to trigger a strong reaction from consumers. Especially when we haven’t seen the same reaction across the board with the other recognized credit rating agencies. We are even seeing reports of credit ratings of Canadian banks being unofficially upgraded by less-recognized sources in the financial industry. Investors will choose to listen to one report or the other. To one advisor or another. And each will act accordingly to the quality of their instinct and intelligence.
On the other hand, let’s not ignore any dykes in need of repair. Credit rating agencies serve a great purpose and we wonder and watch how Moody’s, Standard & Poor’s, Fitch and DBRS will react to the current quarterly reports from Canada’s big five banks.