Fundamental Trading Diary

Fundamental analysis of the capital markets

Bitumen & Bolts

Canada, the second largest country in the world by landmass, is home to 30 million people.  It’s the most economically comparable nation in the world to the United States: just at 1/10th scale.    After being more fiscally conservative than Americans — and rather smug about it, particularly after the 2008 credit crisis — a bi-polar economic structure has emerged which undermines the illusory Canadian prosperity.

Canada’s economic architecture is a two-headed beast:  it is a strong exporter of both raw materials & finished goods, most notably automobiles & military hardware (I’ll bet you didn’t know that).  The vast majority of trade is with the United States.

The durable goods manufacturing & export industry was reborn out a cheap Canadian currency, created out of the ashes of a tight monetary policy & populist anti-American political stance by Pierre Trudeau.  In the following years, fiscal & weak monetary policy crafted the Canadian economy as the first major manufacturing out-sourcing hub.  Canadian workers were as educated & productive as their

American counterparts, but cheaper, and their health benefits already paid for by the provinces. Coupled with strong government incentives, this ultimately made Canada very competitive.

The Canadian dollar has served as a proxy for basic materials, most notably oil.  This is a gross misestimation of the Canadian economy, and even just Canadian trade: the price of a commodity, whose gross sales at $70/bbl comprise of 3% of Canadian GDP has driven the currency.  Alberta, which produces 74% of Canadian oil, only shares 14% of Canada’s GDP.  In contrast, manufacturing driven Ontario comprises of more than 40%:  this is another demonstration of the relatively tiny size that oil production is relative to manufacturing.

When oil rises, two key things happen:  Americans buy fewer cars, and the Canadian dollar rises with it, making the much larger manufacturing sector less competitive.  This is what has catalysed the loss of more than 400,000 manufacturing jobs since 2002.

This creates a dichotomous system where the currency “sweet spot” for sustainable productivity across the country & throughout its industries is very narrow.  Current values are almost certainly too high, and this is made obvious by the continually falling industrial production.  Perhaps the most laissez-faire of major central banks, Bank of Canada is singularly mandated to fight inflation, which is performed almost entirely through rates.

The current economic expansionary cycle, which started several months before the American March of 2009 turnaround, was catalyzed by a very poorly covered bank bailout.  The Canadian people, who had been running a Federal budget surplus since 1996, suddenly find themselves with a $64 billion deficit:  the new item on tap is a $75 billion bailout (multiply this by 10x to compare it to the US programmes), which creates a massive — for Canada — $64 billion deficit.  What makes the Canadian bank bailout even more curious is how big it is relative to how few banks operate in Canada.  The banking spectrum is dominated by 5:  Toronto Dominion, Canadian Imperial Bank of Commerce, Royal Bank, Bank of Montreal & Bank of Nova Scotia.

Stephen Harper has sworn up and down at every opportunity that the Canadian banks weren’t bailed out, the Canadian banking system is the safest in the world, there is no sub-prime lending, and most recently against a co-ordinated global bank tax to pay for the bailouts.  The only problem is that it’s all untrue.

The Canadian federal government has long been captured.  Regulatory capture has killed financial competition & innovation, creating a system where retirement funds are funneled through a closed system.  As a customer of Canada’s largest bank, Royal Bank, you can expect to pay $28.95 per transaction, plus 2.5% currency fee if you buy American stocks!  The swift, uncontested & uncovered bailout neatly demonstrates the extent of the capture.

So – what does the Canadian economy, architected to sell expensive oil & cars to the United States, do when Americans can no longer afford either?  Spin up the FIRE economy, of course.  Open the credit spigots, lower the borrower requirements & quality, and spur domestic consumption.  This is how Canada’s mighty balance of trade fell from a surplus of 46.9 billion in 2008 (or 47.9 billion in 2007) to a deficit of 4.8 billion.

The position of the United States in trade has dominated global economics for decades.  The cycles of growth & decline of American consumption have driven a high degree of synchronicity in the global economy.  Because of this, most every tradeable asset is highly correlated, and perhaps more than two thirds of any trade is simply whether money is flowing in or out of risk-taking assets.  This is even more true for the Canadian economy, and Canadian assets:  as the largest exporter to the United States, the livelihoods of millions are very sensitive to what American consumers do.  Additionally, the quick federal government support to Canadian banks in late 2008 provided opportunities to scoop up American assets on the cheap, which they amply took advantage of.  This has increased the exposure of the Canadian economy to the American risk even more.

The Canadian Mortgage & Housing Corporation (CMHC) is a crown corporation — fully owned by the state — which serves as an analogue to Fannie Mae or Freddie Mac.  From 2003 through 2007, they removed price ceilings (paving the way for what are called “jumbo loans” in the United States), added 40-year mortgages, removed the requirement of a down-payment, and opened itself up as a Mortgage Backed Securities marketplace (which has comprised more than 90% of the Canadian mortgage market since 2007).  In order to facilitate continually expanding housing prices, the borrowers obviously must grow progressively less qualified; in this capacity, the CMHC is actually riskier than Fannie or Freddie, who were merely over-leveraged, but not big players in the sub-prime markets.

The price-to-rent ratio has gone from less than even in 2001 to over 2.5:1 — at a peak level, after a small decline during the credit crisis.  The price-to-income ratio has gone from almost -2:1 to 1.5:1.  Canadian household debt has reached a record $42,000 a person, ranking Canadians as highest debt-to-income ratio in the developed world.

All of this adds up to a tremendous sensitivity to prices & confidence as in any classic example of a debt-fueled bubble.  Unless wages can quickly rise by 20-30% to cover the un-affordability introduced by credit expansion, or Canada invites an extra million-or-so wealthy immigrants from Taiwan, Canadian home sellers will quickly run out of greater fools.  There is evidence that this has already begun:  new home listings have once again reached an all-time peak, while sales have already leveled & declined from their highs.  At the same time, Canadian consumer insolvencies (bankrupcties & consumer proposals) are up 20% year-over-year.

None of this is good news for the Canadian banks — the top 4 of which own 169 billion in MBS, or foreign MBS owners like General Electric.  Additionally, it’s not good news for the loonie, whose cretinous investors’ distorted views of the Canadian economy has made it a proxy to oil.  Where will the loonie be after credit reverts to mean, and the Canadian government, which insures all of those MBSs, has to pony up from the losses these assets are certainly going to take?

The answer is much lower than it is now, and probably where it should have been all along.

Images, links & data: Mish1 Mish2 americaCanada


June 11, 2010 Posted by | Uncategorized | 4 Comments