Canada’s financial stocks took a breather Monday after a torrid four-month rally that put them on the verge of overtaking energy as the best performing sector in the equity market this year.

A gauge of the country’s insurers, asset managers and banks has soared nearly 26 per cent since the end of March on strong earnings results and a robust capital market. That rally hit a snag on Monday as Canadian banks slipped by as much as two per cent, its biggest intraday decline in nearly two weeks.

“I think today’s selloff is likely linked to the relatively softer inflation print (especially the core inflation metrics), which would imply lower expectations for rate hikes later in the year,” said Shalabh Garg, analyst at Veritas Investment Research, in an email. “Rate hikes are beneficial for the banks from a margin perspective and could help supplement the robust performance in their capital markets and wealth businesses.”

Consumer prices eased in Canada last month, with a key measure of core inflation dropping below two per cent for the first time in nearly six years.

Strong capital markets driven by volatility have been a boon to financial companies, banks in particular. Personal and commercial banking segments have also held up. The country’s financial regulator — Office of the Superintendent of Financial Institutions — lowered capital requirements for lenders for the first time in three years in June, providing another tailwind for firms.

The key to financials leapfrogging energy producers is growing profit, according to Philip Petursson, chief investment strategist at IG Wealth Management. Earnings per share for banks are expected to grow by about nine per cent on a blended forward 12-month basis, according to data compiled by Bloomberg.

“I think the banks are lined up well to deliver on strong earnings growth,” Petursson said. “Don’t expect the same kind of returns that we’ve enjoyed through the first half of the year. But what we see come through in earnings, and what might be left over after any modest multiple contraction, is upside.”

To be sure, financial stocks face their own challenges. Jefferies analyst John Aiken said July 8 that the banks trade at an average of 15.3 times their projected earnings over the next 12 months. That is 50 per cent above the historical average and the ratio eclipsed the previous high of 13.5 times back in February 2006.

  • RBC fined $4.25 million for making inaccurate credit card claims
  • This TSX stock could be a winner as Mark Carney beefs up defence spending

“While valuations in the banking space are elevated, I think they are justified in the near term for the Big Six, given the relative stability in credit performance, solid EPS growth, minimal risk of disruption from AI tools, and recent capital relief provided by OSFI,” said Garg in the email.

Gains in financials had been led by Bank of Montreal, IGM Financial Inc. and Great-West Lifeco Inc. — each climbing by at least 35 per cent this year. A separate index tracking Canadian banks has jumped nearly 30 per cent so far this year, while a gauge of energy shares rose nearly 27 per cent in the same period.

“The banks have had obviously a great run, some better than others,” said Petursson. “If you look at it, we’ve seen returns between 20 per cent and 40 per cent — I think maybe even a little bit higher year-to-date out of the banks.”

While Petursson said bigger returns will be harder to come by, he doesn’t “think the banks are set to see any kind of significant downside.”

“There’s no economic catalyst that would justify that. But consolidation and only modest upside from here? Yeah, I think that’s realistic,” he added.

Financial stocks make up more than 36% of the Canada index, with energy in the second place with a 17% weight.

Energy stocks have been fluctuating alongside developments in the conflict in the Middle East and the reopening of the Strait of Hormuz, a key waterway for trade. The group surged after the United States and Israel launched airstrikes on Iran in late February. Brent crude peaked at around US$118 a barrel on March 31, and traded near US$89 on Monday.

“Energy stocks had momentum early in the year, and then that faded. Money is coming out of the sector, and in Canada, there’s only so many places to go,” National Bank of Canada analyst Gabriel Dechaine said by phone.

“Banks have been the beneficiary” of fund flows, Dechaine said, especially since gold stocks — another major group tied to geopolitical upheaval — have been losing momentum.

Bloomberg.com