Canada’s Bad Week (Or The Best Recession Ever)

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Perennial pessimists like myself have been waiting for something to go wrong with the Canadian economy for some time. But years have passed and the economy continues to defy logic. Despite abundant consumer debt and a housing bubble of record proportions, and an economy dependent on volatile material and natural resource markets, disaster has forever loomed but never struck. And while the TSX hasn’t always been the strongest performer, the Canadian stock market has proven to be quite resilient over the past few years.

TSX performance YTD, July 24, 2015. Yahoo Finance
TSX performance YTD, July 24, 2015. Yahoo Finance

That may be coming to an end however. The TSX has had five negative days in a row, following a sudden cut in Canada’s key interest rate. This is the second unexpected cut this year, dropping the lending rate from 1% to 0.5%. Energy prices remain quite low, off 50% from their high last year, and severely stunting Alberta’s economic engine. The Bank of Canada (BoC) was reportedly taken by surprise by the negative GDP numbers for April, marking four consecutive months of GDP contraction and edging us closer to an “official” recession of two consecutive negative quarters. Just this week the BoC predicted a $1 Billion deficit, challenging the Federal Government’s expectation that they would have a $1.4 Billion surplus.

Joe Oliver flees reports after refusing to take questions
Joe Oliver flees reports after refusing to take questions
The price of West Texas Crude, over the past 18 months. From NASDAQ
The price of West Texas Crude, over the past 18 months. From NASDAQ

The optimism that surrounds Canada’s economic future is an unspoken assumption that a reviving US economy floats all boats, just maybe not this time. As the United States economy continues to improve, the Federal Reserve continues to remain optimistic about raising the lending rate, a sign of burgeoning economic strength. Canada is going the other direction, and for now it seems, the two economies are diverging.

Things could still turn around; the Canadian economy has shown surprising resilience so far, and our falling dollar could very well help super charge the Ontario manufacturing engine, or the price of oil could begin a steep rise (it has in the past) and restart the Alberta economy. But the challenges faced are fairly enormous. 

But if I’m concerned about one thing, it seems to be the general Canadian obliviousness to the problems we are facing. The National Post called this the “Best Recession Ever”, because of how little has changed despite the worsening GDP. The BoC’s June Financial Service Review highlighted that the biggest threats to the Canadian market would be “some event” that would make it difficult for Canadians to service their ballooning debt, but that such an event was “very unlikely”. That was despite the collapsing oil price and the sudden need for two interest rate cuts.

 Optimism can easily become denial as “experts” twist themselves into knots attempting to explain how risks are really benefits, danger is really safety and hurricanes are only storms in teacups. And while business news thrives off of both controversy and hyperbole, there is also a vested interest in making things seem like they are under control. The news should be exciting, but never give the impression that the experts don’t know what is going on. Thus, everything is explainable and only in hindsight do we acknowledge just how out of control it seemed to be. Whether this is the case for Canada right now is hard to say. But the risks associated with Canada have been large for some time, and they have been ignored, dismissed or marginalized regularly by experts within the media. Being a smart investor means facing those risks honestly and acting accordingly.

The Three Most Dangerous Things This Morning

This week three big issues are defining the financial landscape

Greece Isn’t Done Yet!

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Despite a no vote in Greece over the weekend, the EU still believes it is within the collected interest within the Eurozone to stop Greece from imploding. Strong resistence seems to be coming from Greece on this issue as the Greek Prime Minister, Alexis Tsipras, swanned into Brussels with Cheshire cat grin and nothing in hand to negotiate with. Greece has five days to work out a plan with its creditors before being declared in default. While the Greek situation seems to be playing out at a glacial pace, the fact is that these tactics can only go on for so long, and eventually (presumably by the end of the week) a point of no return will be passed and negotiations will be moot. The stakes are high as a Greek default, while not insurmountable by European leaders, risks creating problems in other member states. That contagion is at the heart of German reluctance to cut Greece any slack and it is the real concern that is adding volatility to the market. Markets would like to see a sensible conclusion to the Greek problem since it will reassure everyone that the larger plan for Europe is still in place. A chaotic Greek exit from the euro could simply make matters worse.

China: Start Panicking and Throw Things!

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Ghost CitiesFor years people have scratched their heads at the curious case of China. China’s economy is huge and somewhat a mystery. Like most big economies, the government makes predictions about the future of economic growth. Unlike most big economies those predictions are always right and never need any revision. In addition to China’s always correct economic growth numbers, China has embarked on massive infrastructure projects. So massive that they’ve built entire cities where no one lives. This combination of big spending and highly suspect numbers has made many people wonder whether there is a looming problem within China that has yet to rear its head.

That problem may have arrived this month. The Chinese stock market has lost close to 40% over the last month and the government has had to step in to try and stop the collapse. So far that hasn’t worked. Prices in China have surged over the last few years as many smaller investors have not just placed money in the market, but borrowed to do it as well. While there were rules to stop “leveraged market mania” within the Chinese market, like all rules they were both weakened over time and people have found ways around them (you can read more about that in this May report: Credit Suisse Report on Chinese Leverage).

China has a market bubble and it’s in the process of deflating. Just this spring 20 million people opened stock accounts, while whole towns have given up farming so that they can play the markets. The Chinese government isn’t oblivious to this problem, and has taken extreme action to try an prop up the market, but whether that will work has yet to be seen. Meanwhile concerns that the market is collapsing is driving many investors to sell, exacerbating the situation.

Canada in Recession? What’s a Recession?

bocCanada’s economic situation is…unclear. At least, that’s the best case scenario. The regular reports from the Bank of Canada, The Financial Systems Review, which details risks within the Canadian market and has regularly highlighted that the indebtedness of Canadians poses the single greatest risk to the economy. If the economy were to change in any way that made servicing those debts impossible the effect would be serious. Since the December report, the Bank of Canada had made an unexpected rate cut to help prop up the economy which was being affected by the falling price of oil. The June FSR (which you can read HERE) stated the same thing, but hoped that an improving American economy would also float Canada’s economic boat. But shortly after publishing several things went wrong. It was revealed that the Canadian economy had contracted four months in a row, with the last month coming as a complete surprise to the BoC. Today, news got worse that Canada has had a record trade deficit, and combined with other bad news gives weight to the likelihood that Canada is already in recession. While this will add pressure for a rate cut, the real message here is that the Canadian market is far more dangerous and volatile than many investors think. That’s something that Canadians reviewing their portfolios should be highly aware of as they consider their retirement nest eggs.