Juggling Dynamite

Over the past couple of years I have noted a lot of people espousing hope that Canada will be able to avoid much of the global downturn and/or rebound faster than other western countries from the global recession. This weekend John Mauldin (a commentator who I respect and often agree with) reminded me of this theme when he wrote:
“…this is a global problem and primarily one in the “developed world”. I think we will find that much of Europe will be in a worse state of affairs than the U.S. If there are bright spots in the developed world, I tend to think they will be Canada and Australia/New Zealand.” See This Time It's Different.
Most often this type of optimism rests on a few key ideas such as Canada has a resource-based economy, Canada has a sound banking system, and Canada has been more fiscally conservative. While I generally agree with these ideas in the abstract, in reality I am concerned that decoupling hopes are still as wishful now as they were last Spring, when many were opining that the Canadian stock market would be able to hold up in the midst of a global bear market. As the past 12 months wore on, investors learned the hard way again that Canada lags; we don't decouple. Our stock market peaked (a year ago) in May 2008, 7 months after the US markets, but then fell a similar 50% to March 2009.
Our housing market has been declining for just the past year, now off nationally about 8%. Muted by American standards, no doubt, but then we are not through the decline yet either. Canadian household debt as a share of disposable income soared pretty much in lock step with American consumer debt over the past 9 years, and is now much higher than that of Britain or the Eurozone. See Globe chart this weekend in Why Carney's caution is warranted.
The Canadian government have been as utterly clueless as any other in anticipating the timing or extent of this global recession. Unforeseen budget deficits have recently ambushed their plans for fiscal conservatism, inspiring speculation this week of a non-confidence vote to oust the Harper government. The truth is that the other parties would not have planned for this downturn any better than the conservatives, decoupling optimism and economic naiveté transcends party lines.
Until very recently the Bank of Canada was assuring those who would believe of a strong rebound for Canada in 2010. This week Governor Carney scaled hope back allowing that Canada could be in for the equivalent of a “long and anxious time”.
The hope that Canada can rebound quickly by continuing to sell rocks and trees in the midst of a collapse in western world demand is simply delusional. Economist Paul Krugman reminded us of why in comments he made about Germany last week:
“Germany has huge inadequacy of domestic demand. Their economic recovery in the first seven years of this decade rested on the emergence of gigantic current account surplus.
How is it possible that Germany, which did not have a house price bubble, is having a steeper GDP fall than anyone else in the major economies?
The answer is that they depended upon exporting to the bubble regions of Europe, so they actually got side-swiped by the loss of those exports worse than the bubble regions themselves got hit.” See full interview: Paul Krugman's fear for a lost decade.
Canada is a great country to live in. It is also America’s biggest trading partner. Like Germany our domestic demand amounts to just less than 2/3 of our GDP. Those who hope we have been selling our goods and services to “other customers” than the ones currently in the global consumption downshift are likely to discover this bubble now burst.

Today the risk trade continues to be under attack with the US dollar strengthening against other more emerging economies. As I have pointed out a few times in the past couple of months, the over-exuberance in emerging markets, commodities and their currencies, has been primarily speculation against the US dollar and not in response to increasing global demand or economic expansion. These sentiment driven speculations can be wild and reckless; capital protective strategies are needed.
A few key themes are slowly seeping into the collective consciousness at this point:
1. A flood of bonds for sale has driven existing bonds prices down and bond yields up over the past few weeks. This is pushing up rates across the curve.
2. Mortgage rates have followed suit and ballooned out. The Freddie Mac measure of U.S. 30-year mortgage rates shows that there has been a sharp 77 basis point increase in rates over the past three weeks, reaching a level of 5.59%. Other measures suggest an even larger increase. This is the highest level since November of last year.
3. Rate pressures have been equivalent to a 133bps rate hike by the Fed in the US and a 20bps rate hike by the BOC in Canada. The gap between the fed funds rate and the 30-year mortgage rate is now huge, with the release of the June data it will rise back towards record-high territory of around 5.39%. As recently as May 2007 it was less than 1.00%. So while fed fund rates are at record lows of just 0.00-0.25%, mortgage rates have managed to very significantly decouple from the central bank’s actions. This has effectively removed a significant portion of the stimulus efforts for recovery that the governments have been working to implement.
4. Although rates still may seem relatively low on a historic basis, it is the absolute increase in rates that has the hardest impact on over-levered companies and people. A loan rate of 5.6% may sound low, but not if you were levered to the max when rates spreads were 1%. It amounts to more than a 500% increase in carrying costs.
5. The next wave of mortgage resets and delinquent commercial loans are about to take another swipe at corporate earnings both for banks and most other companies. It’s very hard for any sector to escape the depth and breadth of this broad recession.
6. Responding to the falling US dollar, oil prices have risen more than 100% over the past several months, levying another substantial drag on the struggling economy.
7. Tax hikes will be needed to help support fiscal spending which has already been announced.
8. As the US dollar has weakened, export nations (like Canada and others) have been hit with another impediment to selling our goods—they are more expensive just when we desperately need them to be affordable.
9. Although there has been evidence of some inventory re-stocking over the past 3 months, we have so far not seen a confirmation in the transport sector. In other words, there has been a pick up in some orders but there has been no evidence of a pick up in shipments to end users. This is the reason that Dow Theory holds you need to see new highs in both the industrials and the transports to confirm an expansionary cycle. Re-stocking of inventories is not enough to signal a pick up in demand unless goods are also being shipped out. So far shipping, transports and rail are all pretty much at a standstill.
10. The airline industry has said that it is seeing twice the decline in world air travel this downturn as it did after 9/11. (read this sentence again-it is remarkable)
The net effect of these factors is likely to be a continued economic malaise and much slower economic recovery in 2010 than world stock markets have recently been pricing.
Gold meanwhile has broken down once again. Unless and until gold can make a run through $1000, inflation is not likely to be in the picture and rates are likely to stay at the lower end of the historic range. The longer-term effect of the stimulus spending may one day be inflation, but in the short and medium term, over the next couple of years, deflation and disinflation are likely to be still at the fore.
The stock and commodity markets seem ripe for a reality check in the weeks ahead. Price risk measures high once again.

It was with much sadness that I heard this weekend of the passing of Peter L. Bernstein at age 90. Peter was a rare voice of wisdom in the often misguided world of finance.
His perspective was rare and valuable because it was anchored in real world experience spanning 9 decades, conveyed through a remarkable intellect and gift for teaching. In a world too often led astray by confident formulas and theory, Peter was an academic and a pragmatist. He spent years as a front-line practitioner managing money for clients at the investment counsel firm his father had founded in the 30's. After serving in the War, Peter joined his dad's firm in 1951 just in time for the big secular bull of the 50's and 60's when stock market gains were above average and concern about risk faded into a phase of systemic complacency.
After his dad died, Peter sold their company in 1967 which turned out to be almost exactly at the peak of the bull cycle; since a secular bear in world stock markets began in 1966 and continued all the way until 1982. Peter stayed on as a manager until 1973 when he quit the management business horrified at how little traditional finance theory was serving real world investors in the new bear climate. He spent the next 35 years writing and teaching investors and practitioners about the risks and realities of theory and our investment behaviour.
Peter was a mentor for me personally for the past several years after I stumbled on to his remarkable book: “Capital Ideas: The improbable origins of modern Wall Street.” I went on to read all of his books, and many of his articles. A few years ago as we were founding our money management firm, I was grateful for Peter’s kind correspondence and encouragement as we designed a tactical management system designed to protect our capital from down market cycles.
While the conventional wisdom of the industry insists on passive, long always exposure to equities through a full market cycle, Peter assured me that we were correct to reject this approach in the interests of better protecting our clients. I was able to meet him personally two years ago and it is a memory I will always cherish.
Peter led a long and remarkable life, and he was sharp and inspiring unto the end. I will miss him. Fortunately we will always be better for the wisdom of his work which will live on so long as there are some of us who care enough to read and understand it.