A Canadian Story of Woe

 

drowning
A Canadian homeowner going for a relaxing swim in his mortgage…

 

One of the challenges of being a financial advisor is finding ways to convey complex financial issues in simple ways to my clients and readers. I believe I do this to varying degrees of success, and I am informed of my failures by my wife who doesn’t hesitate to point out when I’ve written something boring or too convoluted.

One such subject where I feel I’ve yet to properly distill the essential material is around the housing market. While I’ve written a fair amount about the Canadian housing market, I feel I’ve been less successful in explaining why the current housing situation is eating the middle class.

In case you’re wondering, my thesis rests on three ideas:

1. The middle class as we know it has come about as a result of not simply rising wages but on sustained drops in the price of necessities.
2. The rise of the middle class was greatly accelerated by the unique historical situation at the end of the Second World War, which split the world into competing ideological factions but left the most productive countries with the highest output and technological innovation to flourish.
3. A global trend towards urbanization and a plateauing of middle-class growth has started reversing some of those economic gains, raising the cost of basic living expenses while reducing the average income.

The combination of these three trends has helped morph housing from an essential matter of accommodation into a major pillar of people’s investment portfolios and part of their retirement plan. The result is that homeowners are both far more willing to pay higher prices for a home in the belief that it will continue to appreciate into the future, while also attempting to undercut increases in density within neighborhoods over fears that such a change will negatively impact the value of the homes. In short, stabilizing the housing market is getting harder, while Canadians are paying too much of their income to pay for existing homes. All of this serves to make the Canadian middle class extremely vulnerable.

 

Household Debt
You may be tempted to think “Wow, debt levels really jumped through 2016” you should remind yourself that this chart STARTS at 166%!!!

 

Proving some of this is can be challenging, but there are some things we know. For instance, we know that Canadians are far more in debt than they’ve ever been before and the bulk of that debt is in mortgages and home equity lines of credit (HELOC), which means much of that debt is long-term and sensitive to hikes in interest rates. We also have abundant evidence that zoning restrictions and neighborhood associations have diligently fought against “density creep”. But to tie it all together we need the help of HSBC’s Global Research division and a recent article from the Financial Times.

FT Global Leverage

Last week, HSBC issued a research paper on global leverage. Providing more proof that since 2008 the world has not deleveraged one bit. In fact, global debt has settled just over 300% of global GDP, something that I wrote about in 2016. An interesting bit of information though came in terms of the country’s sensitivity to increasing interest rates. Charting a number of countries, including Canada, the report highlights that Canadians (on average) pay 12.5% of their income to service debt. A 1% increase in the lending rate would push that up over 13%. For a country already heavily in debt, a future of rising rates looks very expensive indeed.

It would be wrong to say that fixing our housing market will put things right. There is no silver bullet and to suggest otherwise is to reduce a complex issue to little more than a TED Talk. But the reality is that our housing market forms a major foundation of our current woes. A sustained campaign to grow our cities and reduce regulatory hurdles will do more to temper large debts that eat at middle-class security than anything I could name.

What “The Big Short” Can Tell Us About Market Risk

I81wBzBcSclL‘ve just had a chance to watch the movie The Big Short, based on the book of the same name by Michael Lewis. Michael Lewis has made a name for himself as a writer for being able to explain complex issues, often involving sophisticated math that befuddles the general population but is responsible for much of the financial chaos that has defined the last decade.

The principle of our story is Dr. Michael Burry, a shrewd investor whose unique personal qualities gives him the patience to tear apart one of the most complicated financial structures in modern finance. Having done that he creates a new market for a few people who had the foresight to see the US housing bubble and how far the crash might reach. The story is captivating and the tension builds to what we know is the inevitable conclusion of the worlds biggest crash, but there is a problem with the story.

No matter what they do in the movie, we know how it all ends. That hindsight undercuts the real tension in the film, the risk that these few traders and hedge fund managers took with other people’s money to bet against what were largely considered to be safe investments. In some ways, the US housing crash is unique because of how much institutionalized corruption had seeped into the system. The ratings agencies who sold their AAA ratings for the business, the mortgage brokers who pushed through unfit candidates into subprime adjustable rate mortgages, the analysts and financial specialists that repackaged low grade mortgages into AAA rated bonds; it took all of them and more to create the biggest market bubble since the South Sea.

Their smart move seems like lock, but if you look past the drama the heroic brokers of our story were taking a huge gamble with other people’s money. From Dr. Michael Burry down through the rest of the characters, hundreds of millions, billions even, were tied up in investments that few understood but carried incredible potential for losses. The confidence that our heroes show in demanding “half a billion more” as they come to understand the scope of the problem seem smart in hindsight, but they were making big bets. Bets that could have easily ruined people’s lives and finances.

This is the true nature of risk. Things are only certain in hindsight. At the moment we need to make decisions rarely do we possess the kind of clarity that we believe we should have when dealing with markets. If we look to current markets what can we honestly say we know about tomorrow? Markets are chaotic, oil prices are in the tank, central bankers are talking about negative interest rates (while some have gone and done it), and then we will have 2 or 3 days of market rallies. What picture should we draw from this? What certainty do we have about tomorrow’s performance?

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From Bloomberg

Our problem is that when we are inclined towards certainty we are also inclined towards fantastic risk. In fact we won’t even believe there is risk if we are certain of an outcome. And we are prone to lionizing people who risk it all and are proved to be right, while forgetting all those people who made similar gambles and lost everything, leading us to repeat a mistake that has undone many.

The story we need isn’t the one about the people who bet big and won. We need the story about the people who bet smart and navigated confusing and risky markets and came out fine. That story sadly won’t have the kind of impact or drama that we long for in a movie, but it’s the story that each and every investor should want to be part of.

Hyperbole and a Half: Terrible Financial Advice

bear market

Walking into my office this morning I was bracing for yet another day of significant losses on global markets. It’s a tricky business being a financial advisor in good or bad markets. But seeking growth, balancing risk, and managing people towards a sustainable retirement (a deadline that looms nearer now with every passing year) only grows more challenging in terrible markets like the ones we are in.

In some ways it can seem like divining, working out which thread of thought is the most crucial in understanding the problems afflicting markets and panicking investors. Is the rising US dollar enough to throw off the (somewhat) resurgent American manufacturing sector? Has China actually successfully converted its economy, and is no longer requiring infrastructure projects to drive growth? Is oil oversold, and if so should we be buying it?

Aiding me in this endeavor is the seemingly boundless supply of news media. There is never a moment in my day where I do not have some new information coming my way providing “insight” into the markets. The Economist, the world’s only monthly magazine that comes weekly, begins my day with their “Economist Espresso” email I get every morning. No wake-up period is complete for me without glancing at the Financial Times quickly. My subscription to the Globe and Mail and the National Post never go unattended. Even facebook and Reddit can sometimes provide useful information from around the planet. After that is the independent data supplied by various financial institutions, including banks, mutual fund companies and analysts.

So what should you do when the Royal Bank of Scotland (RBS) screams across the internet “Sell Everything Before Market Crash”.

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The answer is probably nothing, or at least pause before you hit the big red button. It’s not that they can’t be right, just that they haven’t exactly earned our trust. RBS, if you may recall, was virtually nationalized following losses in 2008, having 83% of the bank sold to the government. In 2010 despite a £1.1 billion loss, paid out nearly £1 billion in bonuses, of which nearly 100 went to senior executives worth over a £1 million each. In 2011 it was fined £28 million for anti-competitive practices. In short, RBS is a hot mess and I suppose it is in keeping with it’s erratic behavior that it should try and insight panic selling the world over with a media grabbing headline like this.

I may be unfair to RBS. I didn’t speak to the analyst personally. The analyst was reported in the Guardian, a newspaper in the UK whose views on capitalism might be best described as ‘Marxist’, and inclined to hyperbole. It’s not as though I am not equally pessimistic about the markets this year, nor am I alone in such an assessment. But it should seem strange to me that an organization whose credibility should still be highly in question, who undid the financial stability of a major bank should also be trusted when calling for mass panic and reckless selling.

The analyst responsible for this startling statement is named Andrew Roberts, and he has since followed up his argument with an article over at the Spectator (I also read that), outlining in his own words the thoughts behind his “sell everything” call, essentially spelling out much of we have said over the past few months in this blog. I find myself agreeing with much of what he has written, and yet can’t bring myself to begin large scale negation of sound financial planning in favour of apoplectic pronouncements that are designed as much to generate headlines and attention as they are to impart financial wisdom.

Panic Selling

The point is not to be dismissive of calls for safety or warnings about dire circumstances. Instead we should be mindful in how we make sense of markets, and how investors should approach shocking headlines like “sell everything”. I am not a fan of passive investing, the somewhat in-vogue idea that you can simply choose your portfolio mix, lean back and check back in once every decade for a negligible cost. I advocate, and continue to advocate for ongoing maintenance in a portfolio. That investors must be vigilante and while they should not have to know all the details of global markets, they should understand how their portfolios seek downside protection. My advice, somewhat less shrill and brimstone-esque , is call your financial advisor, discuss your concerns and be clear on what worst case scenarios might mean to your portfolios and what options are available to you. If you don’t have a financial advisor, feel free to reach out to us too.

Concerned about the markets and need a second opinion? Please drop us a line and we will be in touch…

 

Swiming With Rocks in Your Pockets

drowningSince 2008 governments the world over have tried to fight the biggest banking collapse since the great depression with modest success. Eight years on and you would be loath to say that the world has turned a corner, ushering in a return of unrestrained economic growth.

Why this is the case is a question not just unanswered by the average layman, but by experts as well. Huge amounts of money have been printed, financial institutions have been patched and repaired, interest rates are at all time lows, what more can be done to fix the underlying problems?

It turns out that nobody is really sure, but as we begin 2016 global markets are reeling on the news that the Chinese economy has even greater problems than previously thought. Only a few days into the week and most markets are down in excess of 2-3%, giving rise to concerns that a Chinese led global recession could be on it’s way.

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The S&P/TSX over the past week.

The difference between now and 2008 is that much of the resources used to try and stem the problems from nearly a decade ago have already been deployed, and there is little left in the tank for another round. Central bakers have been trying to get enough inflation into the system to raise interest rates up from “emergency” levels to something more “normal” but outside of the US this seems to have largely failed.

One of the saving graces after 2008 was that the Emerging Markets were seemingly unaffected. In fact, since 2008 the developing world has become more than 50% of global GDP but in that time the rot that often accompanies success has also set in. EM debt is now considerable, putting many countries that had once extremely healthy balance sheets heavily into the red. Borrowing by these nations has increasingly moved away from constructive economic development and more into topping up civil servants and passing on treats to voters.

World GDP

For some, myself included, it has been encouraging that the Chinese have not proven to be the economic übermensch that some had feared. The rise of the state directed economy with boundless growth had many people concerned that China might represent an economic nadir for the planet. To see it every bit as bloated, foolish and corrupt may not be good for markets, but at least takes the bloom off the rose about Chinese economic supremacy.

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Still, this all of this leads to a couple of frightening conclusions. One is that we have yet to come across any rapid comprehensive solution to a global financial crisis like 2008 that can undo the damage and return us to an expected economic prosperity. The second is that we may have been going down the wrong path to resolve the economic problems we face.

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If debt was the driving force behind 2008, you couldn’t argue we’ve done much to alleviate the problem. At best we have merely shifted who holds it. In the United States, the US government took on billions of dollars of debt to stabilize the system. In Europe, despite attempts to reduce balance sheets across the continent, every country has taken on more debt as a result, regardless of whether they are having a strong market recovery, or a weak one. In Canada, arguably one of the worst offenders, private debt and public debt have ballooned at a frightening pace with little to show for it. Rate cuts and government spending are no match it seems for a plummeting oil price and a lack lustre manufacturing sector.

Interest Rates Globally

Having faced the problem of restrictive debt, putting much of the world’s financial markets in grave danger, our response has been to simply acquire more. Greece owes more, Canada owes more, and now the Emerging markets owe more. It was as though while trying to right the economic ship we forgot that we should keep bailing out the water.

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These charts come from an excellent report by McKinsey & Company called Debt and (not much) Deleveraging. You can download it HERE.

 

None of this is to say that every decision since 2008 has been wrong. Following Keynesian policy saved countless jobs and businesses. But at some point we should have also expected to tighten our belts and dispose of some of the debt weighing us down. Instead central banks attempted to stimulate inflation by juicing the consumer economy with incredibly low interest rates. But as we have seen there is only so much that can be done. A combination of persistent deflation, an aging population and extensive debt have largely upended the best efforts to restart the economy on all cylinders.

Economist cover

This shouldn’t be a surprise. Debt makes us financially fragile. It is an obligation and burden on our future selves. But if we found ourselves drowning in debt eight years ago, it is curious we thought the solution would be to add rocks to our pockets and expect to make the swimming easier.

 

Walking the Tightrope

Tightrope-Graph_181538393_crop02As we bring this year to a close, markets continue to frustrate. The US markets, along with most global markets and especially Canada, are all negative. Over the past few weeks Canada has dipped as low as -13% on it’s year-to-date (YTD) return. In speaking with some people within my industry, expectations to finish flat for the year will be sufficient for a pat on the back and considered solid performance.

Years are ultimately an arbitrary way of organizing time. January 1st will simply be another day from the standpoint of the earth and the sun. Neither China’s nor Canada’s problems will have solved themselves when markets reopen in 2016, but from the perspective of investors a new year gives us a chance to reframe and contextualize opportunities and risks in the markets. The surprises of 2015 will now be part of the fabric of 2016, new stories will come to dominate investor news and new narratives will popup to explain the terrain for Canadians.

So when we do get to our first trades in January, what kind of world will we be looking at? What opportunities and risks will we be considering?

The risks are very real. After a steep sell off in Canada we may be tempted to think that the Canadian market is cheap and ideal for investment. I’ve had more than one conversation with market analysts that suggests that things could change very quickly. Cheap oil, a cheap dollar and rising consumer spending to the south could all spell big opportunities for Canada.

S&P TSX Index
Though it has recovered substantially since the lows of early 2009, the TSX is a real underperformer. It’s last high was August of 2014, and since then has simply lost ground. It is also hovering now around its 2011 value.

But this argument has another side. Since 2007, despite lots of volatility, the TSX has barely moved. In February of 2007 the TSX was at 13083, and at close on Friday last week the market was 13024. The engines of Canada’s economic growth from the past few years have largely stalled. Commodity prices have fallen and may be depressed for some time, with exports of everything from timber to copper and iron being reduced significantly. Oil too, as we have previously said, is unlikely to bounce back quickly. Even if oil recovers to around $60, the growth of cheap shale energy will likely eclipse Canadian tar sands, and will not be enough to restart some previously canceled projects.

 

MSCI EM Chart
MSCI EM: The MSCI Emerging Markets index has shown solid losses this year, but has yet to regained it’s last high at the beginning of 2011, and has been sideways and volatile for the past few years.  

Similarly, the Emerging Markets have been badly beaten this year, driving down the MSCI EM Index to levels well below the early year highs. But those levels also reflect the ongoing and worrying trend. The MSCI EM Index (a useful tool to look at Emerging Markets) isn’t just lower than it’s previous year’s high, it’s lower than it was back in 2011, and in 2007. In other words we’ve yet to surpass any previous highs, and when faced with the reality that the United States will likely be raising rates for the next few years, the EM will likely continue to lose investments to safer and higher yielding returns in the United States.

 

MSCI EAFE
MSCI EAFE: The EAFE has faired better than some others, but closing in on the end of the year we look to be at roughly where we were at the beginning of 2011. The MSCI EAFE Index is a benchmark to measure international equity while excluding the United States and Canada.

In an ideal world a new year would be a chance to wipe the slate clean, mark the previous year’s failings as in the past and move forward. But what drives markets (in between bouts of panic selling and fevered buying) are the fundamentals of economies and the companies within them. So as celebrations of December 31st give way to a return of regular business hours, investors should temper any excitement they have about last year’s losers becoming the new year’s winners. The ground has shifted for the Canadian economy, as it has for much of the Emerging Markets. Weaknesses abound as debt levels are at some of their highest and global markets have largely slowed.

It is a core belief that investors should seek “discounts”. The old adage is buy low and sell high. That advice holds, but investors should be wary as they walk the tightrope between discounted opportunities, and realistic market danger. Faced with a world filled with worrying trends and negative news an even handed and traditional approach to investments should be at the top of every investor’s agenda for 2016.

The Financial Challenges of Being a Young Canadian

Meanwhile, at Starbucks
Meanwhile, at Starbucks

It is a common enough trope that people do not save enough, either for retirement or just generally in life. We are a society awash in debt, with some estimates showing Canadians carrying an astonishing $27000 of non-mortgage debt and an average of three credit cards. This financial misalignment, between how much we spend (bad) and how much we save (good) is a source of not just economic angst, but denouncements of sinfulness and failings of moral behavior.

This isn’t an exclusively Canadian problem. Pretty much everyone across the developed world has been accused of both not saving enough and carrying too much debt, and the remedy is usually the same, save more and spend less. Underneath that simplistic advice is the nuance that goes into managing money; the importance of paying down debt, of saving some of what you earn on payday (so you don’t see it) and a host of other little things that define good money habits.

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This TTC Subway car is built in Thunder Bay. Because Toronto needs more subways, because it is a desirable, albeit expensive place to live.

But for young people trying to save and spend less they may find that the struggle is far greater than anticipated and the advice they are given can be frustrating in its obtuseness. For instance, one of the first solutions financial gurus give is “cut back on the lattes”. In one of our first articles we ever wrote was about the “Latte Effect”, (That Latte Makes You Look Poor) and how the math that underlies such advice, while not bad, isn’t going to fund a retirement.

In fact cutting costs is extremely difficult. Vox.com recently offered some advice for saving more. Pointing out that big ticket items are more useful in cost cutting than small items, the article made the improbable suggestion to “consider moving to a cheaper metropolitan area” if you are finding San Francisco or New York too expensive. Seriously. As though living in cities was a choice exclusively connected to cost, or that Minneapolis was simply New York with similar opportunities but cheaper.

In Canada this advice falls even flatter. While you can live many places, not all offer similar opportunities. Living in Windsor means (typically) making

As a financial advisor I am required to spit on the ground and curse when the subject of credit cards comes up.
As a financial advisor I am required to spit on the ground and curse when the subject of credit cards comes up.

cars. Thunder Bay offers both lumber production and a Bombardier plant. But if you are part of the 78% of Canadian GDP that is connected to the service sector, either through banking, finance, health services, government, retail, or high tech industries you are likely in one of four major cities, Toronto, Vancouver, Calgary or Montreal. It should be no surprise that young Canadians, facing ever increasing house prices haven’t actually abandoned major cities for “cheaper alternatives” since most of the jobs tend to be concentrated there.

full-leaf-tea-latteSo for young Canadians the challenge is quite clear. Cutting back on your expensive coffees could save you between $1000 – $2000 per year, but that won’t get you far in your retirement. Serious changes to costs of living are challenging since the biggest cost of living in cities is frequently paying for where you want to live. In between these extremes we can find some sound advice about budgeting and restraining what you spend, but it is fair to say that many young people aren’t saving because they enjoy spending their money, but because they don’t yet have enough money to cover their major costs and maintain a lifestyle that we generally aspire to.

It’s worth noting that most financial advice is pretty good and sensible, even things like watching how much you spend on coffee. Credit cards, lines of credit and overdrafts are all best avoided if possible. A solid budget that allows you to clearly see your spending habits won’t go amiss. And if you do choose to spend less on the small luxuries, it isn’t enough that the money stays in your purse or wallet. It must go somewhere so it can be both out of reach and working on your behalf or you risk spending it somewhere else.

At university and have no income? How about a credit card?
At university and have no income? How about a credit card?

But it is financially foolish to assume that people don’t want to save. The Globe and Mail recently ran a profile on the blogger “Mr. Money Mustache” – a man who retired at 30 with his wife and claims that the solution to retiring young is to wage an endless war on wasteful spending. And he means it. Reading his blog is like reading the mind of an engineer. From how he thinks about his food budget, to what cars you own, his advice is both sound and confounding. It might be best summed up as “live like your (great) grandparents”. Sound advice? Absolutely! Confounding? You bet, since the growth in the economy and our standard of living exists precisely because we don’t want to live like our grandparents.

There is no good solution or answer here. Young Canadians face a host of challenges on top of all the regular ones that get passed down. Raising a family and buying a home are complicated by financial peer pressure and inflated house prices. Choosing sensible strategies for saving money or paying down debt (or both) often means getting conflicting advice. And young Canadians have no assurances that incomes will rise faster than their costs, nor can they simply relax about money. They must be vigilant all the time and avoid financial pitfalls that are practically encouraged by the financial industry. Finding balance amidst all this is challenging, and young Canadians should be forgiven that they find today’s world more financially difficult than the generation previous.

Throwing Cold Water On Investor Optimism (Not That We Needed Too)

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From The Geneva Report

Yesterday the 16th Geneva Report was released bearing bad news for everybody that was hoping for good news. The report, which highlighted that debt across the planet had continued to increase  and speed up despite the market crash of 2008, is sobering and seemed to cast in stone that which we already knew; that the global recovery is slow going and still looks very anemic.

The report is detailed and well over a hundred pages and only came out yesterday, so don’t be surprised if all the news reports you read about it really only cover the first two chapters and the executive summary. What is interesting about the report is how little of it we didn’t know. Much of what the report covers (and in great detail at that) is that the Eurozone is still weak, that the Federal Reserve has lots of debt on its balance sheets, but that it has helped turn the US

A look at the Fed's Balance Sheet from the Geneva Report
A look at the Fed’s Balance Sheet from the Geneva Report

economy around, that governments have been borrowing more while companies and individuals borrow less, and that economic growth in the Emerging Markets has been accompanied by considerable borrowing. All of this we knew.

What stands out to me in this report are two things that I believe should matter to Canadian investors. First is the trouble with low interest rates. Governments are being forced to keep interest rates low, and they are doing that because raising rates usually means less economic growth. But as growth rates have been weak, nobody wants to raise rates. This leads to a Catch-22 where governments are having to take direct measures to curb borrowing because rates are low, because they can’t raise rates to curb borrowing.

This has already happened in Canada, where the Bank of Canada’s low lending rate has helped keep housing prices high, mortgage rates down and debt levels soaring. To combat this the government has attempted to change the minimal borrowing requirements for homes, but it hasn’t done much to curb the growing concern that there is a housing bubble.

The second is the idea of “Economic Miracles” which tend to be wildly overblown and inevitably lead to the same economic mess of overly enthusiastic investors dumping increasingly dangerous amounts of money into economies that don’t deserve it just to watch the whole thing come crashing down. Economic miracles include everything from Tulip Bulbs and South Sea Bubbles to the “Spanish Miracle” and “Asian Tigers”, all of which ended badly.

The rise of the BRIC nations and the recent focus on the Frontier Markets should invite some of the same scrutiny, as overly-eager investors begin trying to fuel growth in Emerging Markets through lending and direct investment, even in the face of some concerning realities. It’s telling that the Financial Times reported both the Geneva Report on the same day that the London Stock Exchange was looking to pursue more African company listings, even as corruption and corporate governance come into serious question.

All of this should not dissuade investors from the markets, but it should be seen as a reminder about the benefits of diversification and it’s importance in a portfolio. It is often tempting to let bad news ruin an investment plan, but as is so often the case emotional investing is bad investing.

I’ve added an investment piece from CI Investments which has been floating around for years. It pairs the level of the Dow Jones Industrial Average  with whatever bad news was dominating the market that year. It’s a good way to look at how doom and gloom rarely had much to do with how the market ultimately performed. Have a look by kicking the link! I don’t want to Invest Flyer

 

***I’ve just seen that the Globe and Mail has reported on the Geneva Report with the tweet “Are we on the verge of another financial crisis” which is not really what the report outlines.