It sucks to be right

Before we get going, here is the writeup and video for my BNN show last night.

At the end of every calendar year I write a blog on an non-investment related topic that ties into investing in some way. For example, I’ve written on the concept of personal diligence vs. buying a mutual fund—and compared that to shifting your own gears in a car vs. having an automatic transmission. I’ve written on the comparatives between athletic discipline and trading discipline.

The year-end blog that received the most comments, most viewings, and perhaps the most controversy was my 2015 blog entitled “Some pigs are more equal than others”. I’m sure many of you will recall that blog. Unfortunately, it can’t be seen any longer as we can only store about a year’s worth of blogs on this site.

But the concept that I wrote about was this:

Canada is destined to be an underperformer on world markets due to: low commodity prices for the foreseeable future, record high personal per capita debt, and a new socialist government with a tax n’ spend philosophy and arguably the least qualified leader in our history. As our rather inexperienced leader follows his father’s footsteps, TD Bank has forecast that Ottawa is headed for $150B in deficits over next 5 years.

Ironically, asked, after leaving office, if he had any regrets, Pierre Trudeau said yes – he wished he had paid more attention to the economy….sigh!

 

I noted on that 2015 blog that I thought you might see the TSX rise to its old highs (technical resistance).  I presented that level as my ultimate target. I was right. I suggested that the bigger picture from there was bleak for the TSX, and the Canadian economy.

Gosh, it sucks to be right.

The TSX, as noted above, has rallied to its old highs per my target of 2 years ago. And now, the index appears to be struggling right on schedule. Meanwhile, as suggested on the blog, the picture is growing bleaker for the economy. Rather than pretend to be an economist, I thought I would quote one of my favorite research analyst—Larry McDonald. I’ve subscribed to his research for some time now, and will say that his work is more often right than wrong. So I tend to listen when he speaks. I recommend that readers interested in his research check his website and determine if its suitable for your own needs.

Here are two thoughts out of his most recent report on Canada’s outlook:

 

Canadian Markets - TSX monthly chart to mid 2017 showing struggling to break past old highs

 

 

  1. Potential trade wars only enhance the bear case for the loonie.

    “The United States is prepared to kill the North American Free Trade Agreement (NAFTA) if renegotiation efforts don’t result in a better deal for the USA, President Donald Trump said on Sunday. Trump insisted that he was going to terminate the agreement, which links the U.S. to Canada and Mexico, before having a change of heart when the leaders of both countries reached out to him.Last week, shortly after announcing a 20% tariff on Canadian softwood lumber in response to perceived unfair trade practices by Canada on dairy products, the White House announced it is considering an executive order that would pull the United States out of the North American Free Trade Agreement (NAFTA) under Section 2205 of the agreement. The Administration’s recent moves on trade have blindsided those on Capitol Hill who thought Trump had moved in a more moderate direction and would instead notify Congress of an intent to renegotiate the trade agreement under Section 2202. White House sources, however, have stated that no decision has been made.After strained relations with Mexico since Trump’s candidacy, Secretary of Commerce Wilbur Ross said last week was “a bad week for U.S. Canada trade relations.” But the news out of the White House cannot be ignored,  especially given that much of Trump’s legislative agenda has stalled. Withdrawal from NAFTA can be undertaken by the President unilaterally.”

 

Larry goes on to note the yearly trend for Canadian per capital debt vs. GDP, and it ain’t pretty:

Canada Private Debt to GDP

2017: 261%
2010: 223%
2005: 181%
2000: 186%

Source–OECD Data

 

Says Larry:

Canadians have become ever more addicted to sub-prime mortgage borrowing, and it has become a major driver of the Toronto housing market – Home Capital Group’s home headquarters.
Canadian equities look to be facing a triple whammy, as we listed above. What amplifies this problem for Canada is that all of these issues are hitting them head on. The housing bubble is beginning to leak out with big mortgage lenders facing runs, oil has been weakening over the past couple of months which takes their currency lower, and now a trade war with the U.S. is looking dangerous. Equities in Canada have been trading higher this as many of the headline economic indicators such as retail sales and manufacturing growth have turned higher, if that begins to turn as oil and housing falter, equites will respond. Canadian equities look ready to break this recent uptrend as these three things come to a head.  Bottom line: Canadian equities trade just under 17x forward price to earnings and a 2.9% forward dividend.  A forward price to book of 1.78x and a 10.72 forward ROE, they should bounce here but are a SELL on any rally. 
As Canadian exports have become increasingly dependent on oil, the Canadian dollar has traded very close to how oil prices fluctuate. Oil looks to be under structural pressure again as OPEC has not come to an output cut extension yet and U.S. production has soared back to over 9 million barrels a day. Canadian producers also have lower costs, like many U.S. producers, which means they can stay competitive in a lower price environment. However, a big drop in oil revenue will have a big effect on the Canadian economy, both in terms of wages and profits. What makes this worse is that a decline in oil prices would be happening at the same time they are dealing with trade restrictions from the U.S. and a subprime housing bubble mess. 
The divergence in yields in Canada vs. the U.S. tells you what the bond market thinks about the respective economies. Rates are telling you U.S. growth will outperform Canadian growth as the spread between their respective ten year’s, is at its wide for the year. Another aspect playing into this equation is the respective central bank policy actions taking place in the two countries. In Canada, the BoC has struggled to get rates away from zero as the economy has become so levered. In the U.S. the Fed is on a path to hike rates at least one more time this year, and two more times if you listen to FOMC dots forecasts. The market is pricing in a 75bp or greater differential in overnight rates for these two countries by year end, this is will also lead to weakness in the currency. With their overnight rate (Fed Funds equivalent) down at 0.5% for nearly two years, Canada’s growth track has continued to fall behind G8 peers (U.S. / Germany).  The IMF sees Canada’s GDP at1.9% in 2017 and 2% in 2018. While inflation is at 1.6% year over year today, and expected to be moving along near 2% over the next 18 months. Canada is still running a current account deficit of GDP at around 4% to GDP, while real interest rates are well into negative territory.”

Here’s a chart that I have posted before–note the declining trend channel:

Canadian Markets - chart of the Canadian dollar (Loonie) showing continued long-term downtrend

 

 

2. The Canadian economy is likely in recession or very close to one.  

Larry provides some insight into Canada’s economic growth – or lack of it:

“Private debt/GDP is over 250%, personal leverage is over 100%, and government debt/GDP is over 90%. Canada is a highly levered economy with two main engines of growth, services and oil. While oil has traded weaker in recent months, it is not in the same situation it was in 2015. If oil is to return to levels that cause serious pain for domestic producers, the economy will deteriorate. I housing is cracking, and we think it is, the amount of defaults and charge offs will rise, the economy will be holding a lot of bad loans that will have serious deflationary spillovers. 

 

The big problem the BoC has had is that like many central banks around the world, they are in this catch 22 type dilemma. As oil recovered since 2015, they would like to move rates higher but since the economy has levered up with household debt/incomes over 165% and so much money tied to low rates for housing, there is nowhere for them to go. In theory, there will be a need for BoC to cut rates and ease, but that only encourages a bigger buildup in the debt profile. They look stuck until real estate completely falls down, in that case they would need to step in with liquidity. In their April monetary policy update, the Bank of Canada discussed economic downside of a rise in trade protectionism.  They did not come up with data projections, but did suggest that prolonged elevated trade uncertainty could also undermine growth.”

 

 

I continue to endorse an overweighting in US and foreign market securities for the foreseeable future in our equity positions

6 Comments

  • Hi Keith,

    I wonder what will happen Canadian bonds. If the TSX continues to break the trend and heads for 2016 lows, then one would think that ZAG/XBB go up. However, the late mortgage lending problems could spread and get worst, in which case housing could finally correct. If that happens, I speculate that rating agencies downgrade Canada’s debt, which would put pressure on bonds. As a result, this would put pressure on fixed mortgage rates, making debt servicing costs higher. And at that point you’ve got negative feedback making the situation worst. Although, if that happens, Poloz would likely step and add liquidity to the system in order to keep rates from increasing. Just like in the U.S.

    My conclusion: Better to buy U.S. banks over CAD banks, even if their dividends are 50% lower.

    What do you think?

    This weekend, don’t trying biking. Go with swimming…
    Matt

    Reply
    • Yes, we are looking at US bonds for many of the reasons you mention–although a C-bond downgrade may take a while before materializing! And we are biased US securities in our equity model
      Wore my swim trunks to work…

      Reply
  • I share these concerns, and think these 3 factors mean slow growth in Canada for the foreseeable future.

    Reply
  • Thanks for this Keith. Larry McDonald seems very insightful and I will check out his services.

    Just my humble comments on a few things:

    Re. the housing situation in Canada, though much is written in the “national” news, I don’t think the whole truth with respect to the depth of the problem, will be portrayed. Where there is smoke there is fire, or at least a higher probability of fire. The federal gov. and the news media (which will fall in line, especially the public broadcaster) will censor/massage/spin (whatever word you like) the data that is released when it comes to such an important and favored economic sector.

    Re. Oil price, I think there is a possibility there could be some sort of capitulation and the price could see a relatively sharp drop in prices. I don’t think the fundamentals supports oil less then 48-50 for the next year. I hold only one long term position, Suncor bought at $34, and would relish the opportunity to double it if it got back down to that price again. The same could be said for a few select others. Being selective is the key for me at this time, which is why I am starting to factor in fundamentals more into my trading decisions as well as longer term investments. The media is missing the point again (like in 2014) by focusing on the oil price and missing the broader commodities picture. I agree about the USD likely heading higher over time which is a negative for commodities. This could lead to a huge opportunity for selective individual resource companies that are not only getting more profitable but will grow still further through acquisition. It’s already happening, just have to use the weekly charts to time these thematic opportunities.

    Cheers, Ron

    Reply
  • “THE OIL WENT THROUGH A FLASH CRASH OVERNIGHT, PUTTING AN ALREADY FRAGILE MARKET ON EDGE”(CNBC) : OPEC COMPLIANCE… NOT A DONE DEAL!

    TORONTO MARKET:

    $SPTMT: DOWNSIDE POTENTIAL AT 212
    $SPTEN: DOWNSIDE POTENTIAL AT 180
    $SPTFS: DOWNSIDE POTENTIAL AT 265
    TSX CLOSING BELOW RISING TRENDLINE (EQUITY CLOCK)
    WHAT’S LEFT IN THIS MARKET… STAPLES?

    Reply
    • We still hold a few unique situations –but yeah–pickings are thin out there!

      Reply

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