The largest bank in Canada closed at its 52-week high on Tuesday – none other than The Royal Bank of Canada (
(Source: Company Presentation)
Now, my concern is more around a potential increase in interest rates, which is a few years out. If COVID-19 puts people into a bigger crunch, we will continue to see consumer debt increase and mortgages defer. There are a lot of people taking “advantage” of the low rate environment and getting loans of all kinds, including mortgages, which is all fun and games until that rate increase hits. We will see this on a very large scale with the Government of Canada due to all the debt the country has taken on due to COVID-19. Back to housing, I do think there is a big correction coming, as the housing market across the country remains inflated. This, mixed with rate increases, could be catastrophic. The Canadian housing market did not really feel the pinch that the US housing market did in 2008/09, and is well overdue. Royal Bank of Canada published the following outlook in its Q3 slides:
… we expect housing prices to contract by 4.1% over the next 12 months, with a compound annual growth rate of 4.8% for the following 2 to 5 years. The range of annual housing price growth (contraction) in our alternative downside and upside scenarios is (29.6)% to 6.1% over the next 12 months, and 2.3% to 11.1% for the following 2 to 5 years
That low end is a scary number for many, but it’s something I think is coming at some point. Whether that is actually in the next 12 months, I don’t know, but a move like that would be devastating to families across the country, and the banks could get caught with their pants down as we saw in the US years ago. Yes, I know there were other factors at play.
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(Source: Company Presentation)
The Oil & Gas sector is the second headwind I will mention today. I will be brief because I am bullish on the sector, but worldwide lockdowns could cause price pressure once again, especially if there is a lack of travel over the holiday seasons, which is expected. The good news is that the price of oil has been rallying really well and is at an 8-month high as I type this. However, RBC is less bullish than I am. Its forecast is included below:
… average price of $42 per barrel over the next 12 months and $48 per barrel in the following 2 to 5 years. The range of average prices in our alternative downside and upside scenarios is $22 to $48 per barrel for the next 12 months, and $35 to $49 per barrel for the following 2 to 5 years.
Personally, I think the bank is on the low end here. But if this is indeed where prices remain over the next 2-5 years, I think Royal Bank will feel some pressure in terms of defaults. There are a lot of companies with substantial debt that comes due in the next 2-4 years. If they cannot get back to $50 oil, they are in trouble when it comes to paying those debts off. Royal Bank has at least made note of this in the Q3 presentation, as seen above. I am very curious to see how its forecast has changed, if at all, over the last few months.
The good news is that Royal Bank of Canada is well-diversified and should not be shell-shocked by a few oil loans going bad. If that is mixed with a faulty housing market, there could be trouble in paradise. But enough doom and gloom. As of now, we can see the light at the end of the tunnel, and the Royal Bank is sitting in a fairly solid position.
How Is The Dividend?
If you are buying any Canadian bank stock at these current levels, it has to be for the yield. Anytime these banks are showing yields over 4%, you should be taking a look at buying on dips for a long-term income portfolio. Royal Bank of Canada is currently posting a yield of 4.01%! The stock has long been over 4% until this recent run which saw the value of the stock increase 20% over the last month. One of the big things to consider when looking at dividend payers is the rate of increase. While the rate has slowed over the last few years, moving from 8% down to 5%, it is still fairly solid. Looking forward, we can see that analysts are projecting that the dividend does not increase. I think we might see an increase in mid-late 2021 if the world can get back on track and COVID-19 takes a backseat.
One of the other things to keep an eye on for dividend stocks is the payout ratio. As it sits right this second, it is around 55%. Looking below, we can see a quarterly history of the payout ratio. We did see this spike up over 105% in Q2 due to the impacts of COVID-19, but as you can see, this was short-lived. The company has done a very good managing the dividend over the years and did not cut in 2008/09. There is absolutely nothing to be worried about in terms of a cut.
The only point in which I could imagine Royal Bank even considering a cut is if the Canadian housing market collapses beyond belief. Even then, I think the people of RBC would be smart enough to avoid cutting due to some sort of financial engineering. Companies like Royal Bank are extremely protective of their dividend, and for good reason. It is the largest reason to own the stock today.
What Does The Price Say?
Royal Bank has been on quite the run as of late, along with the entire market, as folks begin to see the light at the end of the COVID-19 tunnel. The stock closed at a 52-week high on Tuesday evening, thus fulling recovering from the generational buying opportunity in Canadian banks. I do not think that this is a value play at this point, and Seeking Alpha’s quant rating would agree, as the value is rated at D+ right now. As mentioned above, if you are buying today, it would be for the dividend and the long-term “safety” that the Canadian banks offer.
Looking above, we can see just how great the climb back to pre-COVID-19 levels has been. If you managed to pick the absolute bottom, you would be looking at just shy of a 70% return, which is really good for a bank. Looking below, I looked at the major moves the stock has made since 2008, and these moves of 70%+ are fairly rare and usually take much longer. The move we saw in 2009/10 is the outlier at this point, but I think everyone can agree the economy was in a much worse spot at that point as well.
Looking at this makes me think there is room to run, and given the 52-week high we established today, I am bullish on Royal Bank for now. But I do not think this is going to run 40%+ in the next couple of months. I think we could see a period of static while the stock resets to where it was a year ago. Hitting just over $87 is going to be an all-time high, which is less than 5% away. As I mentioned earlier, I do not think the economy is in a spot where banks should be hitting all-time highs. That isn’t to say they can’t, I just do not think it is sustainable at this point. If you are buying into the bank for yield and safety, I do not think you can go wrong with Royal Bank, but this is not going to be a sexy stock to own.
As you can see, it may take a few years for you to get 70% out of Royal Bank of Canada if you buy today. But what you do get is Canada’s largest bank, with a yield of 4%. That is something that cannot be overlooked. The dividend will continue to grow over time and add to your long-term savings. The risks are there, but the bank is diverse enough that it should be able to weather most storms, just as it did for the majority of 2020. You can sleep well at night owning Royal Bank knowing your money is working for you. Stay safe out there!
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.