Juggling Dynamite

Auto makers are releasing April sales numbers today and so far, all are reporting a fourth monthly decline, sending their share prices lower. See Every major carmaker whiffs on sales.

After seven straight years of prodding purchases with increasingly lax lending and uber-generous incentives, disappointment and mean reversion are due. No expansion can last forever, especially one this inherently self-destructive. Canada for one, has never had higher household leverage as shown here since 1990.

Weak auto sales weighed down consumer spending and hurt GDP growth in the first quarter. A year over year decline in 2017, would mark the first since the last recession.

At the same time, the other debt-enabled piston of the consumer-led economy–real estate and related services–is looking more precarious as mortgage magicians meltdown. This chart shows the spread from industry leader Home Capital to the shares of the other non-bank lenders who helped to fund Canada’s consumer debt bubble the past 8 years.

So far the broader Canadian financial sector index (XFN) is only down some 2% since March 1, 2017. But we should make no mistake, bank lenders are also heavily exposed to both household credit and the commercial realty sector.

As shown below, realty operators are now a full 14% of the business loans held by Canadian banks–more than oil and manufacturing loans combined.  Note that real estate operator loans have led since the oil and manufacturing sectors turned down in 2014.

If the concerns here were contained to just a few borrowers at the margin, that would be easier to overlook. But debt burdens and shrinking revenues are the rule today, not the exception. And knock-off effects connect from the economy through the stock market, which in Canada is about 70% concentrated in just energy and financial shares.

This means that all of the mutual funds, ETFs and asset allocators who are all set up to track the broader index, are also over-exposed to the financial and energy sectors, as both move through a secular consolidation likely to persist for several years.

Tracking markets up is great, it’s tracking them back down that sets holders back years in wasted time and money.  And yet, that’s precisely what most advisors, managers and products, are designed to do.

Every year at tax time many of us submit our income receipts to accountants and trust that they will prepare our financial statements and tax returns in accordance with the latest laws and our best interests.  That’s inherent in the professional service, right?

Except increasingly we have noticed a disturbing trend of accountants in the investment advice business.  In a world dangerously obsessed with ‘cross-selling’ to increase revenues, many accounting firms have formed ‘wealth management advisory’ divisions and are making unsolicited recommendations of products and services to their clients.

This is problematic on many fronts.  First all because tax advisors are using their privileged position and information as our accountants to increase their own fees by selling investment management services.  Second, accountants know lots about tax efficiency and nothing about managing capital risk of publicly traded security portfolios.

The most classic example, is accountants saying we should buy and hold, but not sell assets, where doing so triggers capital gains tax.  What about the fact that market cycles drive asset prices up and then the gains are given back in the down cycle?  Sure taxable gains disappear when prices mean-revert, but how is that progress? Remember Nortel anyone?  Bad things happen to capital, when tax planning dictates investment timing decisions.

Another classic example, is the recommendation that we should put cash into dividend paying securities rather than bonds and guaranteed deposits because dividends are given a preferential tax rate.  Sure, but what about the downside risk, where companies go bankrupt and shares can go to zero, or over-valued common and preferred shares drop 50% in a market downturn as they did in 2000-3 and 2008-09?  How does a lower tax rate on income help, when capital losses evaporate years of it and chunks of our principle each market cycle.

Finally, the ‘genius’ of tax shelters recommended by accountants or tax lawyers have frequently harmed those who bought them over the years.  When tax authorities reassess these securities or ‘strategies’, the taxes owing, penalties and compound interest falls on the clients not the tax experts or fees they collected for their recommendations.  I have personally known of several people who were reassessed with devastating financial impacts, years after the fact, in some cases after they had already retired and could not afford to make the repayments.  I know of two people who actually committed suicide thereafter.  This is no joking matter.

As investment counsel, portfolio managers, we spend all our time focused on the best, unbiased financial advice for our clients and what will grow their net equity, while minimizing losses, in a world full of harmful advice, huge capital risk and lots of product salespeople.  We have quite extensive tax planning education and understanding, but we never try to overstep our expertise and hand out the accounting advice to our clients.  Nor do we try and channel them to a different accounting firm that has offered to pay us referral fees for the favor.  We should all be very wary of accountants and tax lawyers who seek to overstep their own expertise and make investment management recommendations and referrals.

This weekend in my home town of Barrie (1 hour north of Toronto), I spoke to three people who reminded me of the compound costs of Canada’s latest debt-fueled real estate mania and why it is unsustainable.

The first was a 22 year old esthetician who also moonlights at the beer store.  She had graduated from a college based training program in 2014 with $30,000 in student debt.  She has been working two jobs, 6 days a week, since.  So far she continues to live in the same student rooming house she has been for the past 3 years, paying $550 a month for a room and shared living quarters with 4 other students.  She no longer qualifies to stay there, and has to move out by August.  For more than a year, she and her boyfriend have been looking, but unable to find, an habitable apartment for less than 1500 a month including utilities.  It has to be on the bus route, they own no car.  They are now hoping a friend can find a job in the area, so that the three of them together can afford to rent a 2 bedroom apartment.

The second was the 30-something owner of the aesthetics business.  She is married with a 4-year old son, and her husband also works full time.  They have been renting and trying to save a down-payment for a starter house.  They are looking for enough space that her aging mom can live with them and help with child care.  Last year they were excited to find a new subdivision being built 15 minutes outside of town on 40 foot lots.  They tried to find a way, but at 650,000 plus taxes and utilities, on top of a car and child care costs, they could not stretch enough to cover all the payments.  They have kept trying to build their savings, but this spring she says, those 650K homes are selling for over a million, up some 400k in 1 year.  They now feel utterly hopeless about ever being able to buy a home.

The third, was a 50 something, government worker who goes to my gym.  In the past couple of years, he gutted the equity in his personal residence to buy 8 other rental properties with minimum down-payments after taking a real estate ‘investment’ course taught by self-styled real estate guru Scott Mcgillevray (who is sponsored by debt-seller CIBC). The rents don’t quite cover his carrying costs for the properties, so he is subsidizing with money from his employment on top of paying his own home mortgage.  But he feels it’s worth it, because prices are only going up!

This is the Canadian real estate association’s chart of home prices in Barrie since 2008.  The average price has more than doubled.  Incomes have not.  Affordability has been completely dependent on the availability of credit.  Increasingly buyers have been high- ratio (5 to 10% down, 95 to 90% financed).

Rates are, so far, still less than 3% for most prime mortgage terms, but the banks have been increasing their credit card rates over the past few months (now over 20% for most), and last week TD sent out notice that is was raising its personal line of credit rates by 3%. Yes, prime plus 4.5% from 1.5%, takes PLC rates from 4.2% to 7.2% starting on May 25.  Most Canadians today are carrying revolving debt on credit cards and lines of credit, on top of car loans/leases, student loans, mortgages/rents and everything else.

Low rates and ‘creative’ financing over the past 8 years in particular, have enabled Canada’s home ownership rate to reach an unprecedented 70%, compared with the long term average of about 64%.  The below chart shows what happened to the US homeownership rate after it soared to 69.2% in the subprime lending bubble in 2004-05.  Note that is has since reverted to the long term average of 63.4%.  It is highly likely that Canada will follow suit, and the buyers who bought, but shouldn’t have, the past few years, will default and return to renting.

This reversion to the mean in prices and ownership rates is essential to restore affordability to shelter costs in Canada. It will happen because, mathematically, it must. The hard part will be that after the oil-rush, a now debt-addicted Canadian economy, is precariously levered to real estate as its last cylinder of growth.  See: Life after oil makes real estate Canada’s new economic crutch.

Lower prices will help restore financial viability in the longer run for those needing shelter (that’s everyone, BTW), but not without defaults, liquidation, capital losses and economic challenges in the process.  This is the bed we have made, the payback period is coming next.