By Fergal Smith and Matt Scuffham
TORONTO (Reuters) - Investors are losing enthusiasm for Canada's banking stocks as a slowdown in the country's housing market dents banks' growth prospects, and they see insurance companies as a better bet to benefit from higher interest rates.
Home sales in Toronto, Canada's largest city, plummeted more than 40 percent in July from a year earlier and prices were down nearly 19 percent from April following the introduction of a range of measures designed to cool a housing market amid fears of a bubble, including a 15 percent tax on foreign buyers.
The slowdown in home sales has investors concerned about the impact on Canadian banks, which derive a big chunk of their earnings from residential mortgages.
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"Once Toronto started getting hit I think the housing fears became much more front-of-mind for a lot of people, said Ian Scott, equity analyst at Manulife Asset Management. "I think now when you get a move higher in yields and you are looking for financial exposure in Canada, the incremental dollar seems to be flowing into the lifecos rather than the Canadian banks," he said, referring to life insurance companies.
The Bank of Canada raised its policy interest rate in July, its first hike in nearly seven years, bringing the rate to 0.75 percent, and economists expect another hike as soon as October.
Although higher rates usually improve banks' net interest margins, Canadian bank shares have stalled, underperforming other financial services sector shares such as insurance companies.
"They are lagging because of questions over how the changes in the housing market are going to be affecting them," said Norman Levine, managing director at Portfolio Management Corp.
Investors like the high dividends that Canada's banks pay but worry that measures introduced by federal and provincial authorities to help slow once red-hot housing markets in Toronto and Vancouver will weaken loan growth.
Measures proposed by regulators include stress tests on uninsured mortgage borrowers.
Higher bond yields reduce the value of insurance companies' liabilities, boosting their earnings.
Manulife Financial Corp <MFC.TO> and Sun Life Financial Inc <SLF.TO>, two of Canada's biggest insurers, are due to report second-quarter earnings after the market closes on Wednesday.
Shares of Manulife and Sun Life have climbed nearly 6 percent since the Bank of Canada turned hawkish in June, while the TSX's banks index <.GSPTXBA> has retreated 0.6 percent over the same period and has added just 0.6 percent since the beginning of the year.
"I think things are beneficial now in the macro area for the insurance companies," said John Kinsey, portfolio manager at Caldwell Securities. "The party isn't over yet."
Kinsey says the rally in U.S. stocks has added to the attractiveness of Canadian insurers, some of which have U.S. wealth management businesses.
Problems at alternative lender Home Capital Group <HCG.TO>, which has been hit by withdrawals of more than 90 percent of funds from its high-interest-rate savings accounts since April, have also weighed on banks. That comes amid concerns about contagion within the broader financial system, though that has failed to materialize.
Rate hikes could also slow the housing market. Economists say that the build-up of household debt to record levels adds to the sensitivity of Canadians to higher borrowing costs.
In contrast to the tougher mortgage rules being introduced in Canada, U.S. banks <.SPXBK>, whose shares have rallied 5.8 percent this year, could benefit from a lighter regulatory environment promised by President Donald Trump.
Some investors have been selling short Canadian banks and going long U.S. banks, which have more attractive valuations, said Matt Skipp, president of SW8 Asset Management. "It has been an American strategy that has worked."
(Reporting by Fergal Smith and Matt Scuffham)