'Investors have a very optimistic outlook in terms of where credit will perform in 2026': Aiken

Key Concepts

Downgrade to Hold: A change in investment recommendation from "buy" to "hold," indicating that the analyst believes the stock's current price fully reflects its future prospects and there is limited upside potential.
Valuations: The assessment of a company's worth, often expressed through metrics like Price-to-Earnings (PE) multiples.
Outlook: The projected future performance or trend of a company, sector, or economy.
Credit Risk: The risk that borrowers will default on their debt obligations, impacting the financial health of lenders like banks.
Provisions for Impaired Loans: Funds set aside by banks to cover potential losses from loans that are unlikely to be repaid.
Macroeconomic Outlook: The overall state and projected future of the economy, including factors like GDP growth, inflation, and unemployment.
Headwinds: Factors that hinder economic growth or a company's performance.
Trade Resolution: The outcome of trade negotiations and agreements between countries.
USMCA (United States-Mexico-Canada Agreement): A trade agreement that replaced NAFTA.
Canary in the Coal Mine: An early indicator of potential danger or problems.
Return to Capital: How a company returns value to its shareholders, such as through dividends and share buybacks.
Capital Relief: The reduction in capital requirements for a bank due to certain asset disposals or integrations.
Synergies: The benefits derived from the combination of two or more entities, such as cost savings or increased revenue.
ROE (Return on Equity): A profitability ratio that measures how effectively a company uses shareholder investments to generate profits.
EPS (Earnings Per Share): A measure of a company's profit allocated to each outstanding share of common stock.

Analyst Downgrades Canadian Banks: RBC and TD Bank to Hold

John Aken, a research analyst at Jefferies, has downgraded his rating on both Royal Bank of Canada (RBC) and Toronto-Dominion Bank (TD Bank) to "hold." This move signifies that he currently has no "buy" ratings on any Canadian bank stocks.

Reasons for Downgrade: Valuations and Downside Risk

The primary driver for the downgrade on both RBC and TD Bank is the assessment that their current valuations are "fully reflective of the outlook." Aken believes that the current market pricing already incorporates the expected positive developments, leaving limited room for significant upside.

The core concern is that if there are any negative "ripples on credit," the downside risk for these banks outweighs the potential for further upside. While Aken acknowledges the strong fundamentals of RBC, describing it as "well diversified" and "best-in-class," he notes that the stock has been "bid up" over the past three months to a point where its valuation is considered "stretched." Specifically, RBC is trading at or just within its "peak PE multiple on a forward basis."

Limited Upside Potential and Fourth Quarter Earnings

Aken anticipates that while fourth-quarter earnings for these banks are likely to be "solid," the positive aspects such as strong capital markets and wealth management are "very well understood in the marketplace" and are already "priced in." He suggests that generating another 10-15% upside would be "very difficult" without a significant change in the macroeconomic outlook.

He explains that waiting for the fourth-quarter earnings report might not provide a clearer picture for investment decisions. While earnings are expected to be good, the potential downside risks lie in credit performance and increased expenses, which typically "tick up in the fourth quarter." Given the current valuations, Aken believes the "balance of probabilities" suggests more pressure than uplift, making it difficult to recommend investors enter at this stage due to "limited upside."

Credit Concerns and Economic Headwinds

Aken's concerns regarding credit are not primarily focused on the immediate fourth quarter, as he hasn't observed significant disruption in the economy, with only a slight uptick in unemployment levels. He expects "provisions relating to impaired loans" to increase, but this is "broadly expected."

However, his broader concern lies in the market's "very very optimistic outlook" for credit performance in 2026. Aken anticipates continued "headwinds in terms of economic growth" and potential increases in unemployment levels. He believes that "things are probably going to get a little bit worse on credit before they get better," with the second half of 2026 potentially showing improvement.

The key headwinds identified for economic growth include:

Lack of resolution in trade with the US: The ongoing trade relationship with the United States remains a point of uncertainty.
USMCA renegotiation: The upcoming negotiation of the USMCA agreement in the next year, particularly given the current negotiation styles of political figures, introduces uncertainty and potential for disruption.

Any disruption in trade is expected to create additional headwinds for economic growth, which in turn will impact the credit outlook for Canadian banks. Aken emphasizes that an increase in unemployment levels is a critical indicator, acting as the "canary in the coal mine" for Canadian banks concerning credit risk, and could lead to a "dramatic reversal in terms of sentiment."

Historical Context and Comparison to Other Sectors

Aken states that he cannot recall a previous instance where he had no "buy" ratings on any Canadian banks, describing this as an "uncomfortable position." He contrasts the current outlook for Canadian banks with other sectors he covers, such as insurers. He notes that insurers are "not as stretched in terms of valuation" and generally have more exposure outside of Canada. His outlook suggests that Canada is likely to face more macroeconomic pressure than the US and the broader global economy.

Catalysts for a Return to "Buy" Ratings

For Aken to reconsider a "buy" rating on Canadian banks, two key factors would need to materialize:

Stronger Economic Growth: This is identified as the "key fundamental" he is looking for. Accelerated economic growth can "hide a whole bunch of bills" and potentially offset an uptick in unemployment. However, he is "not convinced that we're going to see that acceleration in the near term."
Improved Return to Shareholders: Aken expresses disappointment with the current "return to capital to shareholders" from Canadian banks. He believes they are "exceptionally strong capitals" and are "over-capitalizing." He would prefer to see "stronger shareholder buybacks" to boost not only EPS but also ROE.

Recommendation: National Bank

For investors looking for a specific name to watch in the upcoming quarter, Aken recommends National Bank. He highlights two key positive catalysts:

Synergies from Canadian Western Bank Integration: Management has indicated they will provide estimates for additional synergies from the integration of Canadian Western Bank.
Capital Relief and Shareholder Returns: As National Bank migrates Canadian Western Bank's portfolios onto its own systems, it will experience "capital relief." Aken believes that "most if not all of that capital is going to return to shareholders eventually over the next 12-18 months," which is expected to be a "positive catalyst for sentiment on National."

Conclusion

John Aken's downgrade of RBC and TD Bank to "hold" reflects a cautious outlook on the Canadian banking sector. The current valuations are seen as fully pricing in positive expectations, leaving limited upside. Concerns about potential credit deterioration, driven by macroeconomic headwinds such as trade uncertainties and potential unemployment increases, are central to his thesis. While acknowledging the banks' strong fundamentals, Aken believes the balance of probabilities favors downside risk at current valuations. A return to "buy" ratings would likely require a significant acceleration in economic growth and a more aggressive approach to returning capital to shareholders. National Bank is highlighted as a potential positive outlier due to specific integration-related catalysts.