Juggling Dynamite

An IMF report warns that following 16 years of expansionist monetary policies, the world was a record $152 trillion dollars in debt at the end of 2015, more than double the amount owed in 2000. The debt represented 225% of global gross domestic product (GDP), up from 200% in 2002.

The organization further points out that private debt is high not only among advanced economies but also in a few “systemically important” emerging market economies, namely Brazil and China. See:  Chinese policymakers face a difficult balancing act.  The below chart from ANZ shows how China’s credit-to-GDP ratio currently compares to the peak seen in other nations before the onset of past financial crises.  This ratio is calculated by the Bank of International Settlements (BIS) as the difference between the ratio of private non-financial credit to GDP against its long-run trend.

Though the credit explosion over the past 8 years certainly boosted sales and economic activity in the short term, it has also likewise purchased a lower for longer period of economic weakness to follow.  We are there now and no one should be surprised or unprepared.

And as Michael Pento points out asset prices are not prepared for this reality.  The median price-to-earnings, price-to-sales and total-market-cap-to-GDP ratios all show markets as over-valued as the worst bubble peaks in history.  This chart showing the market cap of US equities at 121% of GDP offers some historical perspective as to where we are now, and where prices must mean revert in order to restore long term historical norms.

Total market cap to GDP ratio

Adding debt on debt is not our savior, it is our collective demise. Until we admit and repent this destructive behavior, the global economy cannot reform and recover. In the meantime, downside shocks will continue to mount.

As we have seen repeatedly throughout history, highly levered housing is full of downside for buyers/borrowers, the economy and taxpayers (thanks to government-backed mortgage insurance).  Finally the Canadian government has announced that it wants to introduce ‘risk-sharing” with lenders.  What a novel concept–re-connecting the risk of capital loss on bad loans to those who have extracted front-end profits initiating them! As mortgage lenders and realtors cry foul at the prospect of slowing sales, it is outrageous that it has taken so long for this commonsense nexus to be put back into the lending decision.  See: What Ottawa’s new mortgage rules could mean for Canada’s banks:

Ottawa also announced that it will launch a public consultation in the coming months to examine the possibility of introducing “lender risk-sharing.” This means banks would have to pay a deductible on mortgage insurance provided by Canada Mortgage and Housing Corp. and its private counterparts, and effectively shoulder more of the risk for mortgage defaults.

Banks would also be forced to retain more capital and raise their funding costs, which would likely be passed on to consumers with higher mortgage rates.

“We’ve had some concerns with regards to the Canadian banks in terms of their growth prospects. And when you’ve got Canadian consumers as leveraged as they are, you do have the risk of credit losses mounting, but maybe more immediately is the difficulty in achieving the same rates of growth,” Horan said.

Yes this will necessitate higher down-payments, and less buyers, and that is precisely what is needed to reintroduce some realistic pricing into the real estate equation in Canada.  It should have been this way from the outset.  The mess irresponsible lending policies have made, is all around us, and we will all be paying for the clean up.  See Toronto Life, Mortgages for all:

“…Toronto is where all the euphemisms converge: non-prime mortgage lending to bruised-credit borrowers by less-regulated entities—better known as “shadow lending”—has existed for ages, but it has been on the rise over the last few months in this city, and elsewhere in Canada as well. The Bank of Canada is nervously keeping tabs on the non-prime trend and in the past year has begun sounding alarm bells. “A sizable proportion of new, uninsured mortgages are being issued to riskier borrowers,” it announced last December, calling the situation “worrisome.”

To repeat:  booking sales on things like autos and real estate to buyers who cannot actually afford to pay for them is not business genius, it’s a Ponzi operation that enriches a few for a while and then comes back to exact a painful cost from our economy, household stability and social fabric.  Higher lending standards and lower prices are needed to restore some fiscal sanity and sustainability.  Both appear to be happening now, at long, long last.  See: More evidence Vancouver housing bubble is bursting.

Same goes for the companies that invest in Canadian real estate and are now up to their max in over-valued assets.  This chart courtesy of my partner Cory Venable, shows the Canadian Real estate investment trust ETF (XRE) since 2006 on an ex-dividend basis, and what happened to share prices in 2008-09 (-57%) as well as the loss risk facing holders today.  Down nearly 9% since July, much greater mean reversion is very likely still to come as Canadian realty prices continue to roll over, loan defaults spike and vacancies mount.  Far from the ‘conservative’ income investments, so many thought they were enjoying, REIT holders today have a dangerous tiger by the tail.

As REITs follow real estate into a much deserved repricing cycle, the over-bought Canadian banks (here the XFN in purple) are surely not far behind.  The easy money, lax lending hallucinogens that levitated both sectors over the past 5 years, are due to retreat.

It’s not just Wells or Morgan Stanley…the entire sales-insaitable finance sector is rotten.  See:  “Many other banks around the country will have to review their own sales practices if they want to avoid regulatory scrutiny.” Some further insight into this culture is offered here:

Becky Grimes had trouble enough hitting sales targets as the manager of a busy branch of  Wells Fargo in Austin, Texas. But when she moved to run a Wells branch in a much smaller farming town about two hours to the south in 2011, the same targets — 8.5 products per day, per banker — became too much to bear.It was the sign of an aggressive and pervasive cross-selling culture that forced her into early retirement in 2013, she says — and which has come back to bite Wells, the bank at the centre of a bogus account scandal.

Ms Grimes had four conference calls every day — at 9am, 11am, 2pm and 5pm — during which she was grilled by a district manager on the sales her team had generated. Staff would come to her in the interim, saying they had done a full profiling exercise on a particular customer, but she would have to turn them back to sell more.

“It was pretty ridiculous,” she says. “It bordered on harassment, quite honestly.”