By Prakarsh Jain
Canada, a country having GDP of 1.7 trillion US dollars, sharing its borders with the Global leader and having a currency, which is amongst the most traded in the world. The mingled nature of this country certainly makes an impact on the global economy and any happening around the world should ideally be benefiting or hammering this economy too. Nevertheless, the said has not been the case, the monetary and fiscal policy have been so strong and vibrant that the Global Financial Crisis too did not affect this economy as it would have to other countries.
In recent times, the table seems to have turned. Investors are reacting in a different way than ever. Many investors have started shorting Canadian stocks & dollars and have resorted to buy Canadian government bonds in anticipation of a prolonged downturn. All of a sudden, why this perception. There are certainly substantial risks, which are faced by the Canadian Economy, but the forecast does not justify a prolonged Canadian downturn.
Investors seem to think that the Canadian Market is moving towards dark and duskiness. As American economy picks up after volatile decision on QE, bearish trades known as the great white shorts are gaining popularity in Canada. The question arises, are the investors thinking and acting rational in an expectancy that Canada is about to move from being a champion to chump?
The Domestic Air: Excessive Consumer Debt and Housing
Canada has gained praise for the way it handled Global Financial Crisis, but as we all know, there are no free way-outs for making any mistakes. It goes back in time when the Central Bank reduced the interest rates to historical low and that would have been the day Canadas history would have started to print. It implemented measures as that of its neighbour country, lending to consumers at ultra-low rate of interest and thereon stimuli the economy. The consumer obviously acted rational and borrowed money to buy cars, houses, and other things as per will, not considering the capacity to own it.
As time passed, the regret had to come out, Canadian consumers are highly indebted now, and housing prices are near peak levels.
The sceptics now believe that Canada is in for a major housing correction and that could impair the financial system to cause recession.
The probability is that construction would detract approximately by 0.3 percentage points per year from growth over the horizon as it returns to the average of around 6% of the Canadian economy. The correction does not seem to be that big, why?
The only reason that seems justifiable is that some of the above-average activities of the past were making up for the underinvestment in the housing stock.
Why dont we see a major housing correction?
In general, the population of Canada does not make a residential investment, they buy a mortgage payment that they can afford, and as known around the globe, Canadian mortgage payments are the most affordable as theyve ever been (see Figure 5). The only situation when Canada can have a major correction is when people are having trouble paying their mortgages, which indirectly shall indicate one of these happening:
- Unemployment rate increases
Since 2011, the unemployment rate seems to be steady between 7% and 8% (Figure 6), and barring an external shock, it is hard to foresee unemployment rising.
- Mortgage interest rates rise significantly
The agenda for almost all global central banks seems to be in the same direction, interest rates therefore will remain lower for longer, plus keeping the strength of Canadian dollar into circumstance, it is hard to believe Bank of Canada hiking the interest rates.
- Access to mortgage credit diminishes
The consumers in US have faced this situation when the ABS market seized up. Canada in no way relies on the ABS market to fund mortgages; it usually stays on banks balance sheets. Therefore, mortgages generally are underwritten (see Figure 7).
Housing prices in Canada are certainly overvalued and therefore are due for a correction. A realistic view on the same would be a 10%20% real decline in housing prices over the period of five-years, with sharper corrections in local markets such as Toronto, Montreal, etc. This would be an earnings event for banks, and a current of air to economic growth, as consumption grows with income, and construction declines relative to the rest of the economy.
Europe and disorderly deleveraging:
Europe shall be in the struggling mode for the next five years or so. The base line would be about 0.5% real growth per year. This would make it harder for the Union to implement the structural reforms, which are on books (economic, banking, and political). It is likely that Europe will provide bouts of market stress over the horizon that could potentially make the Canadian business investment and consumer confidence difficult.
Another flashpoint is the resolution of trade imbalances. China is trying to balance its growth model by being more domestically focused. This will be a challenge as it attempts the middle-income transition. There is clearly a risk that this process wont go smoothly, which could lead the market stress washing up on Canadian shores.
The Tailwind-U.S. growth driver of Canadian exports:
Utmost tailwind for Canada is the revival of the private sector of the States, which is the biggest customer for Canada. Since the global financial crisis, U.S. growth has been policy-driven as fiscal deficits hit around 10% of GDP. The forecast remains modest, U.S. GDP growth of approximately 2%, and the composition of growth will likely be favourable to Canadian economy. Canadian exports have been a drag on the growth as U.S. growth was fuelled by federal and state fiscal stimulus. In any case, we cannot forecast the U.S. aggregate real growth, what we can see is a meaningful pickup in private sector growth that could offset fiscal contraction. If things work as forecast, this would be good news for Canada, as its exports would benefit from a bounce in U.S.
Insider tailwinds-Business investment:
Canada is suffering from a lack of business investment, especially during the recovery period from crisis. Why?
Because CEOs are still suspicious that Canada or the globe as a whole is not yet out of the woods, when it comes to certain potential flashpoints such as Europe, US, China, etc. That said, unless and until one of the events materializes, we expect that Canadian businesses will step up their investments over the secular horizon.
Policy Significances-Get working on plan B:
With many potential junctions ahead, policymakers should be working on plan B now. Balancing provincial and federal budgets is important because it allows for cyclical fiscal policy, should a tail event occur. In addition, Canada critically needs infrastructure investments, which are long-term projects that require approvals across multiple levels of government. Canada weathered the crisis relatively better than other developed countries because of the prudent policies that it implemented. Policymakers need to act today to get it prepared for the next crisis.
Investment Significance-New Normal Environment:
For a number of years, investors have been bullish on the Canadian dollar based on Canadas fundamentals. Chinas growth slowing, and the density of future growth slowing, the view on Canadian dollar has changed its winds. Low interest rate translates itself into the potential for low bond returns. The news is that volatility may be a tailwind for active managers to outperform their benchmarks. The high-quality credit spreads, can enhance return potential as bond investors try to escape the financial repression of low yields.
Finally, the belief is that the Bank of Canada will continue to be a credible inflation-targeting central bank; there is the potential for global inflation to reach Canada. In addition, expectations are that the U.S. Federal Reserve would continue its extraordinary loose monetary policy for a long time. Markets have in recent reacted as if that the Fed will be tightening and not just tapering, and the belief is that the Fed would err on the possibility of generating too much inflation rather than snuffing out a fragile recovery. For Canadians, it means more expensive imports and higher inflation. The return on bonds looks to be attractive, relative to nominal bonds in this environment.
Prakarsh Jain is a graduate from Jai Hind College, Mumbai and a Chartered Accountant. In full-strength to continue his passion for studying, he moved on to take up Masters of Global Business in Investment Banking & Wealth Management from S P Jain School of Global Management.In addition, he also acted as a delegate at the World Islamic Banking Conference: Asia Summit. Email ID: prakarshjain@gmail.com