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.

Making Economics Meaningful – How Official Inflation Figures Obscure Reality

Since 2008 (that evergreen financial milestone) central banks have tried to stimulate economies by keeping borrowing rates extremely low. The idea was that people and corporations would be encouraged to borrow and spend money since the cost of that borrowing would be so cheap. This would eventually stimulate the economy through growth, help people get back to work and ultimately lead to inflation as shortages of workers began to demand more salary and there was less “slack” in the economy.

Capture
Following the financial crisis lending rates dropped from historic norms of around 5% to historic lows and remained there for most of the next decade.

Such a policy only makes sense so long as you know when to turn it off, the sign of which has been an elusive 2% inflation target. Despite historically low borrowing rates inflation has remained subdued. Even with falling unemployment numbers and solid economic growth inflation has remained finicky. The reasons for this vary. In some instances statistics like low unemployment don’t capture people who have dropped out of the employment market, but decide to return after a prolonged absence. In other instances wage inflation has stayed low, with well-paying manufacturing jobs being replaced by full-time retail jobs. The economy grows, and people are employed, but earnings remain below their previous highs.

Recently this seems to have started to change. In 2017 the Federal Reserve in the United States (the Fed) and the Bank of Canada (BoC) both raised rates. And while at the beginning of this year the Fed didn’t raise rates, expectations are that a rate hike is still in the works. In fact the recent (and historic) market drops were prompted by fears that inflation numbers were rising faster than anticipated and that interest rates might have to rise much more quickly than previously thought. Raising rates is thought to slow the amount of money coursing through the economy and thus slow economic growth and subsequently inflation. But what is inflation? How is it measured?

One key metric for inflation is the CPI, or Consumer Price Index. That index tracks changes in the price or around 80,000 goods in a “basket”. The goods represent 180 categories and fall into 8 major groupings. CPI is complicated by Core CPI, which is like the CPI but excludes things like mortgage rates, food and gas prices. This is because those categories are subject to more short-term price fluctuation and can make the entire statistic seem more volatile than it really is.

CollegeInflationArmed with that info you might feel like the whole project makes sense. In reality, there are lots of questions about inflation that should concern every Canadian. Consider the associated chart from the American Enterprise Institute. Between 1996 – 2016 prices on things like TVs, Cellphones and household furniture all dropped in price. By comparison education, childcare, food, and housing all rose in price. In the case of education, the price was dramatic.

Canada’s much discussed but seemingly impervious housing bubble shows a similar story. The price of housing vs income and compared to rent has ballooned in Canada dramatically between 1990 to 2015, while the 2008 crash radically readjusted the US market in that space.

The chart below, from Scotiabank Economics, shows the rising cost of childcare and housekeeping services in just the past few years, with Ontario outpacing the rest of the country in terms of year over year change when it comes to such costs.

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My desktop is littered with charts such as these, charts that tell more precise stories about the nature of the broader statistics that we hear about. Overall one story repeatedly stands out, and that is that inflation rate may be low, but in all the ways you would count it, it continues to rise.

DIe6Fh2UMAEDmaIIn Ontario the price of food is more expensive, gas is more expensive and houses (and now rents) are also fantastically more expensive. To say that inflation has been low is to miss a larger point about the direction of prices that matter in our daily lives. The essentials have gotten a lot more expensive. TVs, refrigerators and vacuum cleaners are all cheaper. This represents a misalignment between how the economy functions and how we live. 

DJs5AdwXoAANcDTEconomic data should be meaningful if it is to be counted as useful. A survey done by BMO Global Asset Management found that more and more Canadians were dipping into their RRSPs. The number one reason was for home buying at 27%, but 64% of respondents had used their RRSPs to pay for emergencies, for living expenses or to pay off debt. These numbers dovetail nicely with the growth in household debt, primarily revolving around mortgages and HELOCs, that make Canadians some of the most indebted people on the planet.

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In the past few years, we have repeatedly looked at several stories whose glacial pace can sometimes obscure the reality of the situation. But people seem to know that costs are rising precisely in ways that make life harder in ways that we define as meaningful. When we look at healthcare, education, retirement, and housing it’s perhaps time that central banks and governments adopt a different lens when it comes understanding the economy.

The Interest Rate Awakens

Janet Yellen
Janet Yellen, of California, President Barack Obama’s nominee to become Federal Reserve Board chair, testifies on Capitol Hill in Washington, Thursday Nov. 14, 2013, before the Senate Banking Committee hearing on her nomination to succeed Ben Bernanke. (AP Photo/Jacquelyn Martin)

Today could be a big day. Today the Federal Reserve might finally raise interest rates.

If it does it will be the first time it has done so since 2006. Interest rates, which are precisely nobody’s preferred choice of water cooler conversation, are now the subject of such intense focus it’s hard to know whether we are making too big a deal of them, or not enough of a big deal.

To review, interest rates are used to either stimulate spending or increase savings. If rates are low, we argue that borrowing is cheap and it makes sense to spend money. If rates are high and it costs more to borrow, then people and businesses are likely to save. By this process we can increase or decrease the “cost” of money. Interest rates are therefore considered important in moderating an economy. If the economy is overheating and inflation is rising, raising interest rates should put a damper on it. If the economy is worsening or in recession, lowering rates could inspire companies to spend rather than save and encourage large purchases.

During 2008, in addition to bailouts and massive stimulus packages to the economy, the Federal Reserve in the United States heavily relied on the key interest rates to help stem the problems of the housing and banking crisis. Interest rates went from 5.25% in 2006 to 0.25% in 2008. And they’ve stayed there ever since.

US Fed Fund Rate
A short history of the Fed Fund Rate – since late 2008 the rate has been close to 0%

 

Officially the rate hasn’t moved up, although the Fed has “tightened” credit to the market. Slowing down its bond buying program and ending QE has helped nudge up long term borrowing costs. But eight years on the official interest rate is still near zero, effectively emergency levels, and the economy is (supposedly) vastly improved. So why hasn’t it moved before?

US unemployment
The US unemployment rate has dropped significantly. However there are lingering concerns that while there are fewer people now unemployed, many people are no longer looking for work and have dropped out of the labour force.

 

There is no simple answer to that question. Markets have been nervous, inflation expectations haven’t been met, the USD has risen too fast, unemployment has been too high, the global economy too weak; all of these reasons and more.

US GDP Growth
While it has fluctuated, US GDP growth has been reasonably strong, easily outpacing other global economies of the developed world.

 

But in the background has been a looming fear. That interest rates can’t stay at zero forever. That borrowing can’t be cheap forever. That if the market tumbles again we will have little room to maneuver. That eventually we will have to face significant inflation (and therefore significant interest rates). Those fears seem to have finally won over the largely dove-ish Federal Reserve.

But I want to posit a different thought with our readers. That maybe rates don’t matter as much as we like. Economies are large and complicated things. We only measure what we think is important and traditionally we’ve had to go back and reassess what makes economies work, especially in the face of serious recessions. Where once the Gold Standard was thought to underpin a strong economy, not a single country today relies on it. Where economies were thought to need to correct and businesses fail to right a recession, today we encourage large government spending. Where as we once thought that interest rates shouldn’t be factored into recessions, they are now our first line of defence.

Across the world interest rates are at historic lows to stimulate spending. The BoC recently suggested that interest rates could go negative, a startling and worrying sign for the Canadian economy, especially after two rate cuts this year. But behind this there must be some recognition that the use of interest rates to spur on an economy is at best logarithmic. Like slamming your foot on the gas pedal of a car the most power is delivered early on, not as the pedal reaches the floor.

Logs
Unlike exponential growth, logarithmic growth has a limit that it can not surpass.

 

And so it can be said that perhaps interest rates, currently at all time lows maybe don’t matter that much at all. Maybe you can’t trick people into spending money. Maybe there are limits to what we can do to help an economy. Maybe we have yet to truly identify what ails our economies.

I am of the opinion (in case you haven’t noticed) that the rise of big data may not foretell a future where we can know everything. Far from it, the abundance of data is at best showing that there is still much we don’t know. If the Fed hikes rates today, moving the rates up by 1/4 of a percent, I doubt that there will be any significant change to the economy. It will take years before we approach anything close to “normal” rates at around 2% or higher. In short, a rising rate today will likely mean more symbolically than it does tangibly to the economy.

The Zombie Apocalypse and Investing

If 2008 was the financial apocalypse it is often written about, it is a zombie apocalypse for sure. It’s victims don’t die, they are merely resurrected as an infected horde threatening to infect the other survivors. And no matter how many times you think the enemy has been slain, it turns out there is always one more in a dark corner ready to jump out and bite you.

This past month has seen the return of the zombie of deflation, a menacing creature that has spread from the worst ravaged economies in Europe into the healthier economies of the Eurozone. Deflation is like the unspoken evil twin that lives in the attic. I’ve yet to meet an analyst, portfolio manager or other financial professional that wants to take the threat seriously and doesn’t insist that inflation, and with it higher interest rates are just around a corner.

The eagerness to shrug-off concerns about deflation may have more to do with the reality that few know what to do when deflation strikes. Keeping deflation away is challenging, but not impossible, and it has been the chief job of the central banks around the world for the last few years. But like any good zombie movie, eventually the defences are overrun and suddenly we are scrambling again against the zombie horde.

This. Except it’s an entire economy and it won’t go away.

In the late 1990s, Japan was hit with deflation, and it stayed in a deflationary funk until recently. That’s nearly 20 years in which the Japanese economy didn’t grow and little could be done to change its fate. The next victim could be Europe, whose official inflation numbers showed a five year low in September of 0.3%. That’s across the Eurozone as a whole. In reality countries like Greece, Spain and Portugal all have negative inflation rates and there is little that can be done about it. Pressure is mounting on Germany to “do more”, but while the German economy has slowed over the past few months it is still a long way from a recession and there is little appetite to boost government spending in Germany to help weaker economies in the EU.

Japanese GDP from 1994-2014
Japanese GDP from 1994-2014

Across the world we see the spectre of zombie deflation. Much has been made of China’s slowing growth numbers, but perhaps more attention should be paid to its official inflation numbers, which now sit below 2% and well below their target of 4%. The United States, the UK, the Eurozone and even Canada are all below their desired rates of inflation and things have gotten worse in this field over the summer.

What makes the parallel between this and a zombie apocalypse so much more convincing is that we have squandered some of our best options and now are left with fewer worse ones. Since 2008 the world hasn’t deleveraged. In fact governments have leveraged up to help indebted private sectors and fight off the effects of the global recession. Much of this come in the form of lower (from already low) interest rates to spur lending. But when the world last faced global deflation the cure ended up being broad based government spending that cumulated in a massive war effort. By comparison the debts of the government haven’t been transformed into lots of major public works initiatives, instead that money has sat in bank accounts and been used for share buybacks and increases in dividends.

For investors this is all very frustrating. The desire to return to normalcy (and fondly remembering the past) is both the hallmark of most zombie films and the wish of almost every person with money in the market. But as The Walking Dead has taught us, this is the new normal, and investing must take that into account. Deflation, which many have assumed just won’t happen, must be treated as a very likely possibility, and that will change the dynamics of opportunities for investment. It leads to lower costs for oil and different pressures for different economies. It will also mean different things for how people use their savings for retirement and how they will seek income in retirement. In short, the next zombie apocalypse can likely be defeated by paying attention and not keeping our fingers in our ears.

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If it were only this simple….

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. 

Economists Worry About Canadian Housing Bubble, Canada Politely Disagrees

real-estate-investingThis week the Financial Times reported that “Canada’s housing market exhibits many of the symptoms that preceded disruptive housing downturns in other developed economies, namely overbuilding, overvaluation and excessive household debt.”

These comments made by economist David Madani have been repeated and echoed by a number of other groups, all of whom cite Canada’s low interest rates and large household debt (now 163% of disposable income according to Statistics Canada) as a source of significant danger to the Canadian economy.

This is not a view shared by Robert Kavic of BMO Nesbitt Burns who believes that the Canadian housing market has long legs, saying “Cue the bubble mongers!”

Since 2008 predicting the fall of housing markets has become a popular spectator sport. Canada seems to have sidestepped most of the downturn, which has only made calls for the failing of Canada’s housing markets greater. But the reality is that our housing markets are very hot, and we do have lots of debt.

So is Canada’s housing market heading for a crash? Maybe. And even if it was its hard to know what to do. Fundamentals in Canada’s housing sector remain strong (and have improved). People also want to live in Canadian cities, with 100,000 people moving annually to Toronto alone. In other words, there is lots of demand. In addition regulations in the Canadian financial sector prevent similar scenarios that were seen in the United States, Spain and Ireland from occurring.

But housing prices can’t go up forever, and the more burdensome Canadian debt becomes the more sensitive the Canadian economy will become to interest rate changes. Meanwhile I have grown far more weary of over confident economists assuring the general public that “nothing can go wrong.” 

The big lesson here is probably that your house is a bad financial investment, but a great place to live. Unless you own your home, a house tends to be the bank’s asset and not yours. In addition your home, like your car, needs constant maintenance to retain its value. So if you wanted to buy a house to live in, good for you. If you want to buy a house as an investment my question to you is, “Is this really expensive investment the best investment in a world of financial opportunities?”