As a follow up to our recent report, Canada could be facing a perfect storm, as massive risks mount. If any of the factors below occur, Canada will be in trouble, so the bottom line is, it is critical that things continue as they have and do not return to normalized times, or excesses will be wiped out, and it will be painful.
Here is a further chart on Canadian household debt to GDP.
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This chart is provided by the OECD, The Organization for Economic Co-operation and Development. It is an intergovernmental economic organization with 35 member countries, founded in 1960 to stimulate economic progress and world trade.
The dotted lines reflect the averages for both Advanced economies (developed) and Emerging economies (developing). Levels of debt have been soaring. Canadians household debt as a percentage of the countries GDP is highest in the OECD. They consider Canada a major risk for a fiscal crisis.
Another major world body, The International Monetary Fund has issued a warning to governments that rely on debt-fuelled consumer spending to boost economic growth, telling them they run the risk of another major financial collapse. Canada is at or near the top of this list.
Canada is not the worst culprit if you look at household debt as a percentage of income. Have a look:
In this chart, there are seven countries at higher levels than Canada. That does not mean that Canada is in good shape but instead implies these other countries have levels at nosebleed levels and need to deleverage or a fiscal collapse is inevitable. The growth in these numbers has been staggering. Realistically, world economic growth has been anaemic since the bottom in 2009, and most of the growth that has been there having been driven by increased debt and asset inflation (stocks, bonds, and real estate) which is also attached to higher debt levels.
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An interesting comparison to always look at is Canada relative to the US. Well, as you can see, Canada is at a 175-household debt to disposable income level while the US is at 112. That is a dramatic difference. Canadians have become addicted to debt, while the US deleveraged some of their high debt levels post real estate crash in 2007-11.
So, what does this mean? Well as we stated yesterday, Canada is in a major risk position if:
- Real estate prices must hold firm, as a massive amount of debt, both mortgages, and lines of credit, have been attached to it. Well have a look:
The International Monetary Fund (IMF) is an international organization headquartered in Washington, D.C., of “189 countries working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty.
They are an important and highly regarded organization that has stated that Canada is in a non-enviable position of having the most overvalued housing prices in the world. Look how much higher than they are to the US in terms of housing prices to rent and income. They are at nosebleed territory, their risk is on the downside, as real estate prices are way ahead of themselves.
I have always said, the simple test for real estate is to determine if the prices are reasonable for first-time buyers. Well today, home ownership has become nothing but a dream, or a massive debt proposition for the millennials. Not a healthy situation for the long term. Therefore, real estate is much more of a risk moving forward, while it was a driver since 2009.
- Stock prices have held up reasonably well, but not dramatically beyond the US markets. Let’s look at the Toronto Stock Exchange. Since mid-2000, the TSX is only up 2.0% per year; since mid-2008, it is up 3.7% per year. If you were one of the very smart (and lucky) ones, who invested at the bottom of the market in 2009, you would be up 8.1% per year. Not exceptional, given it was at the end of the biggest financial crisis since the crash of 1929 and the great depression.
Then you must look at the valuation of the TSX today to see if the market presents a good opportunity or is expensive, relative to history.
You generally want to see PE levels in the range of 15 to 18. Being at near 36, the market is extremely expensive today and needs one of two things – earnings that are extremely strong moving forward or the stock market coming down. Given we are closer to the end of one of the longest growth cycles in history, the former is highly unlikely. If earnings end up falling, and they always do in a recession, price earnings will rise even more. During times like this, expect stock markets to fall, and potentially fall hard. So, stocks are very expensive.
The message here is simple, the stock market is significantly overvalued and when it finally moves back down to median levels OR probably below, the crash should be significant.
- So real estate and stocks are shown to be extremely expensive today and at risk. Interest rates have played a big role in driving stocks up as well as keeping the economy modestly healthy. It is simple, the lower the interest rate, the lower the carrying cost of debt. So falling interest rates stimulated the greatest debt frenzy in history. This includes all areas of society: households, governments, corporation and financial firms. Look at this chart to get an idea of how extreme world debt has become:
From 2000 until the end of 2016, global debt outstanding went from $87 trillion to over $230 trillion, an increase of $143 trillion or 164%. That is a massive increase.There was a window to address the massive debt distortions crisis, the world doubled down. As you can see from the chart, debt has gone up by $88 trillion since 2008 which is an increase 62%.
Excessive and we are there, is known to slow growth, and will slow it even further as it is difficult to continue to increase debt at such a rapid pace.
As we started this point, interest rates critical. They have to stay down keep debt payments at a manageable level.But if inflation creeps back in, the only way to address it is to increase interest rates. The US has increased their Fed funds rate over the last 18 months from zero effectively to 1.40% today. That includes 5 increases with 3 to 4 more expected this year.The trend is up, it should continue throughout 2018. Their rate could be mid 2’s to 3% range by the end of 2018.
In Canada, the bank rate was 0.5% and has increased two times since them to 1.0% today. The trend is up here as well, so look for the carrying cost debt to continue to increase. It is important to note that if the US continues of their path of increasing rates, Canada will be forced to increase theirs as well, or you will see the loonie fall much further. is once again negative to the economy, and prices of stocks and real estate.
- The last key requirement for asset prices to stay up is a strong economy. Two key components have led the economy up over the last number of years, real estate prices and increased debt via low-interest rates. Well as we have shown above rising real estate prices has probably ended with the risk of prices falling, possibly significantly, and levels of debt have to slow as interest rates rise and people are maxed out.
The current cycle we are in is very long in the tooth. It is now one of the longest cycles in history, so if the past tells us something, this growth phase should be coming to an end. Here is a look at this and historical cycles:
We are now at 101 months in this expansion. Only the 1990 and 1960 expansions surpassed this one. It should be noted that these previous cycles had much lower debt levels, so there was no concerning on debt expanding; incomes were increasing at a healthy pace unlike today, and demographics were favourable which are not today as we are now in an ageing society where less money is spent. There are many factors against the economy today. The reality is low-interest rates and Central Bank money printing has kept asset price increases alive.
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- This leads to the last point, and that is what Central Banks are doing. They have been a major force of liquidity, putting massive amounts of money into the economy, most of it resulting in asset inflation – real estate, bonds, and stocks. Reality is, most economists and strategists argue that they are the primary reason that stocks and real estate have been very strong in most of the world. Unfortunately, not enough has translated into a better economy or better wages for the average person.
Here is a look at how much stimulus has been injected into world markets, again a reason for massive asset inflation:
You can add $5.5 trillion from the Central Bank of China, and you have nearly $20 trillion on the balance sheets of Central Banks. In 2000, the balance sheets of all Central Banks was lower than $4 trillion, so that is up five times in the last 17 years, unprecedented.
To show how quantitative easing (QE) programs have impacted stock markets, let’s look at the correlation between Central Bank balance sheets and the S&P500:
Coincidence or not, there is a major correlation. You can add collapsing interest rates to this, and the impact has been dramatic.
So what are Central Banks planning on doing moving forward, as they just can’t keep injecting monies into world economies without after effects – these actions should be very inflationary which there are signs now that inflation could become a problem. Remember, when inflation is an issue, interest rates have to rise to combat it.
As you can see, future expectations and goals of Central Banks is to end QE programs, with the result being zero stimuli by mid this year (follow the black line). The US (dark blue) is expected to continue to taper and sell assets back into the market, leading to much less liquidity. China and Russia are expected to do the same. The other major impact will be Europe and Japan who are expected to continue to taper or lower their bond purchases and other asset purchases like stocks. Yes, some Central Banks have become major buyers of stocks including the Bank of Japan and Swiss Central Bank. Crony capitalism at it’s best.
So in summary, Central Banks have pushed markets up with falling interest rates and QE programs. Now that interest rates are rising, and QE is ending, a logical conclusion could be that the reverse will occur. At best, the stimulus here has ended, so they will not be a factor in asset prices on the favourable side.
- Interest rates are rising – big concern as massive outstanding debt will have higher payments and issuance of more debt will be much more challenging.
- Debt levels have increased massively, into dangerous territory. Huge issue, as without major debt increases, economies cannot continue to grow and flourish, but instead can stagnate and contract.
- Central Banks are ending QE programs and reversing course with tapering programs. This ‘funny money’ created a rise in assets and potentially can call a fall in asset prices as we are now on the other side of the mountain.
- Economic growth has been at the lowest level coming out of recession since World Wars. The expansion though is nearly one of the longest in history due to zero interest rates and asset inflation. The economies worldwide are at risk now that the economic cycle is long in the tooth and pent-up buying has ended; interest rates are rising, and Central Banks are leaving the party.
- Stock markets are as expensive as they have ever been. We will show this more in a report coming out soon, but we are at historical highs both in trailing 12 months PE before a crash as well as PE 10 or 10 years PE average. There is little if any room for PE’s to expand up further, a major force that has pushed up stocks.
- The housing market has been a great stimulus to economic growth in much of the world but especially in countries like Canada, Australia, and Scandinavian countries. This sector has been an economic driver. Well, based on history, prices are extended well beyond reasonable levels. In many parts of the world, including Vancouver and Toronto, they are in a bubble state. Bubbles end badly, with a pop. So this sector is played out.
- We will add a 7th risk, and that is that Trump decides to rip up NAFTA and renegotiate. We believe that Mexico has the greatest risks, but clearly, Canada has had huge upside via NAFTA and it’s trade with the US, and Trump has made it clear that the US must always be the big winner.
The message is simple – risks are everywhere. Yes, US stocks continue to rise, but occurrences that you see right at the end of a massive bubble are there, including FAANG stocks and cryptocurrencies. This is so reminiscent of the late 1990’s with .com stocks and other technology stocks that made no sense but soared in price until they crashed and many companies disappeared.
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Our market timing system still has our customers invested, but we are watching closely, as a correction at a minimum, is way overdue. Stock markets are overextended, especially the US markets, but we must always remember that markets can stay irrational for a long period. They always come back to the median and when they do, the pain on the downside will be huge….especially those who have great debt and feel like leverage only works on the positive side.
Chief Investment Strategist