The Canadian economy has made tremendous strides in recent months. But, will it continue on track or is a slide downward imminent? There have been some important data points regarding the Canadian economy in the last 48 hours that I believe continue to make the case for a constructive view on Canada. First, the Bank of Canada announced that it is maintaining its target for the overnight interest rate of 1 percent. Second, Canadian regulators have put forward some additional policy measures to prevent the Canadian housing market from spiraling out of control (up and then likely down). Finally, Canadian commodities are some of the cheapest (a.k.a. most valuable) in the world and with new infrastructure in place, Canada is positioned to prosper for quite some time longer.
A few key points from comments, more or less paraphrased, of the Bank of Canada (one of the most widely respected central banks in the world) include the following:
Global Economic Perspective:
1. The global economic recovery has been proceeding faster than the Bank had anticipated–however they do note that risks remain elevated.
2. Private domestic demand in the United States has picked up a bit.
3. European growth has actually been slightly higher than they expected, however sovereign and bank balance sheets are expected to limit the pace of the economic recovery and could potentially derail the global recovery.
4. Emerging markets remain the source of commodity price inflation. Many of these nations have begun implementing modestly restrictive policies in an effort to slow the pace of expansion from an overheating status. The path forward for commodity prices will essentially rely on these countries’ economic trajectories.
Canadian Economic Perspective:
1. The Canadian economic recovery is proceeding broadly as anticipated by the Bank.
2. The contribution from government spending is expected to wind down this year.
3. Stretched household finances will restrain consumption growth and residential investment.
4. Business investment is expected to increase due in large part to easy monetary conditions as well as “competitive imperatives”.
5. Imports are expected to contribute more to growth going forward.
My take on this: Canada’s economy is following a “normal” business cycle recovery. Monetary policy is still very accommodative and fiscal policy will be adding a modest amount of headwind going forward which should help prevent inflationary pressures from building. On the risk front, the Bank noted two crucial points that every investor with a global mindset must take to heart:
- Risks in the EU remain and have the potential to derail the global recovery.
- Commodity prices are contingent upon the macroeconomic outcome of the emerging markets.
Moving on to my second point: Mortgage rule reform. The Bank of Canada actually highlighted residential investment as a cause for concern regarding Canadian households. What should individual investors make of this? Well, there is concern by a significant number of people that the Canadian housing market may very well plummet similar to the U.S. experience at some point in the near future. However, as reported by Bernard Simon in Tuesday’s Financial Times, “Canada has imposed new curbs on mortgage lending on Monday amid concern about spiraling consumer debt fuelled by high property prices and low interest rates.” Just the headline alone almost sounds like the U.S. housing market part two–barring one crucial point: the Canadians seem to be quite a bit more pragmatic and perhaps more responsible on a regulatory, monetary, and fiscal policy framework.
Jim Flaherty, finance minister, said that the changes, the third tightening in mortgage rules since mid-2008, were designed to encourage savings and insulate taxpayers from risks associated with consumer debt.
Canada’s well-regulated housing sector has been an important strength that allowed us to avoid the mistakes of other countries and helped protect us from the worst of the recent global recession.
According to the FT article, the domestic banks of Canada are required to take out mortgage insurance on any mortgage in which the deposit is less than 20 percent. In addition, the FT article notes that mortgage interest is not tax deductible. These two factors don’t necessarily prove that the Canadian housing and banking sectors are more conservative than their U.S. counterparts but it definitely provides substantial evidence that such is true.
There are almost always two sides to every story. In the same FT article, Mark Carney, the governor of the Bank of Canada, warned that, “without a significant change in behavior, the proportion of households that would be susceptible to serious financial stress from an adverse shock will continue to grow”. This is a far cry from anything that Alan Greenspan ever had to say about the U.S. mortgage market.
What did the Canadian regulators actually do?
- They lowered the maximum amortization period for government insured mortgages with loan to value ratios of more than 80 percent from 35-30 years,
- They lowered the maximum home equity loan limits from 90 to 85 percent, and
- The government will stop insuring home-equity loans–which the FT notes are predominately variable interest loans. To the best of my knowledge the U.S. instituted zero such regulation that aimed to curb mortgage lending. The U.S. took an entirely different approach which has provided the Canadians with a terrific “what not to do” road map of how to handle the housing market.
My final topic for consideration is commodity related. Not all crude oils are the same. In fact the often quoted price of crude oil (NYMEX WTI) is but one of many types of crude oil. Some crude oils are light (measured by their gravity) and some crude oils are sour (measured by sulfur content). Light, sweet crude oils, such as WTI, have become increasingly hard to find and difficult to access. This trend doesn’t seem likely to reverse any time soon. In contrast Canada happens to have a vast amount of natural resources, not the least of which is heavy sour crude oils. This type of crude is technically less valuable than WTI because it yields less gasoline and diesel fuel in comparison to other crudes. However there is always a price that clears a market.
Canadian crudes have been typically so much cheaper than their light sweet counter parts that energy companies have been investing literally billions of dollars in infrastructure so that more Canadian crude oil can be imported and utilized by U.S. refineries. I don’t personally see this trend stopping any time soon. Nothing is risk free mind you, but it is hard to build a compelling case for alternative energy that doesn’t, in part, rely on oil prices increasing to a point in which some sort of alternative energy becomes economically viable and hits a critical mass such that it can legitimately reduce dependence on oil. Long before oil prices ever hit this magical price of economic feasibility, heavy Canadian crude oils will have become an even more strategic resource for the U.S. energy supply and as such Canada is positioned quite well to prosper from this trend.
So my take: I want to continue to hold exposure to Canada for 3 reasons:
- A superb central bank that has so far shown itself to manage the economy quite well,
- Regulators (incl. the Central Bank) that have both hands on the wheel and both eyes on the road with respect to the housing sector, and
- The vast natural resources in Canada are in, and will likely remain in, robust demand long into the future.
Disclosure: I am long EWC.