The Curious Case Of Canada

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Includes: EWC, FCAN, HEWC, QCAN
by: TheBaron Investing

Summary

Currency weakness is being driven by GDP issues, which are not tied to the health of the Canadian economy as directly as we think.

Economic weakness stems from weak commodity prices, an improvement of which would drive the economy well past where it is today.

Concerns about over-leveraged Canadian consumers and high price of Real Estate underestimate the ability of Canada’s Financial System to compensate.

The main investment vehicles within Canada are being dumped along with energy and materials, despite the remaining companies' value and lack of exposure to those assets.

There are opportunities in Canada for those who are bullish and bearish on commodities, and the housing and debt factors are less influential to the thesis than many believe.

Firstly, I heart Canada. It's a solid place to live and I have spent my entire career within the Canadian Financial System. I have recently written a full article on the subject of investment in Canada, you can view here. As a commercial banker, I have seen the issues I hear so many pundits speak about, and I have my own opinions about the very curious case of Canada.

Source

The central bank of Canada, called the Bank of Canada (BOC) shocked all of us when it lowered rates the first time. It then proceeded to shock none of us when it lowered them again. The first time the banks reluctantly accepted their fate, and the second they preempted the argument by proceeding to graciously lower the rate 0.15%, rather than the full amount the BOC lowered it.

It was an attempt to protect their margins while simultaneously preventing a second round of the BOC campaigning against whichever bank decided to try to hold the line. It was a smart business decision, but banks desperately want to prevent a lowering of the rate; is this only to protect their margin, or is there something else?

The Bank of Canada Conundrum

The BOC is seeing waves of data that showcase the perilous position that the consumer is in. They have record levels of consumer debt, real estate prices are particularly high (notably in major markets) and commodities that our currency is tied to have been struggling for years (no longer protected by oil-price outperformance). We are also in the position of entering a recession, two straight quarters of GDP declines, due to the weakness in commodity prices. All signs point to impending doom, so the BOC acted to protect Canadians by lowering rates.

The issue here is… Lowering rates is not going to do anything.

Granted, lowering interest rates punished the Canadian dollar, which is now in a free fall compared to world currencies on the back of ever-lower oil prices, monetary easing policies and GDP weakness. However GDP is a flawed way to evaluate an economy when so much of our production is tied to commodities, which have been suffering terrible prices. The non-commodity world could be ever-improving and we would not know since commodities have been struggling since 2011, taking turns stumbling to finally be joined by oil in 2014.

Monetary easing will help prolong the lives of major commodity companies in Canada, helped by the lower Canadian dollar compared to the commodities that are usually sold in USD. This an lower interest rates, as most companies can finance at some rate based on Prime, at a historic low of 2.85% (and likely headed lower if the BOC starts making banks lower rather than adjusting the Bank of Canada Prime rate, which would be the next step rather than lowering again).

This "prolonging" of companies in Canada will only work if we survive the other numerous other countries and their companies who are also over-producing commodities. If we reach a point where demand begins to pick-up everyone left standing will be very wealthy, but surviving until then is the name of the game. The other end-game is we win the wait and enough competing companies go under to allow prices to rise again.

The Consumer Side

Canadian have a lot of debt or you can view it visually below:

Source: Financial Post

The ratio of consumer debt to disposable income is 163.3%. The other issue stems from Canadians relative reliance on housing for their net worth. For comparison:

Source: Financial Post

As we can see, Canada is approaching the levels seen in the United States prior to its recession, but it's this comparison that is bugging me.

Canada and the U.S. are Very Different

The U.S. financial crisis was awful from what I have heard from others. I live in Western Canada, which means I would have had almost no idea something happened had I not been plugged into the market. U.S. consumer debt was near an all-time high and people were exuberant about housing prices, how they will only go up. The big difference is the financial systems of the two countries, and the different economies, which together should prevent anything like that happening in Canada.

Firstly, Canada's debt is not unreasonable considering how low rates are. Countries such as Denmark, Sweden, Norway, the Netherlands, the U.K. all share similarly high rates of debt to disposable income.

In chart form we can see here, bear in mind this is in 2010, so Canada would sit close to Ireland in this graphic, and the U.S. would be near the U.K:

Source: Fullfact.org

And if we pretend that the debt level is unnatural, let's look at why an instance like what happened in the U.S. is unlikely here.

Financial Systems

The U.S. financial system is a laughable array of thousands of banks competing in this hybrid of free-market and oligopoly protectionism. Twelve institutions control 69% of the industries' assets, with about 5,600 commercial banks in the industry.

Source: ThinkProgress

This seems like an unreasonable concentration, until you learn that Canada is approximately 1/10th the size, and has only 81 community banks, with the Big Five banks' controlling approximately 87% of all assets, along with 100% of trust services and 87% of brokerage services as of 2002.

More recent data compiled by yours truly puts that market share at a similar amount, as the banks below the size listed are close to negligible, as the total deposit base in the Canadian system in 2012 (most information is from there) had total banking assets only a couple of billions larger than my calculated amount. I included the entire Credit Union System for comparison sake, as that would represent the bulk of deposit-taking competition.

As we can see, there is a very massive concentration in the largest banks, whose asset sizes (not listed) dwarf all comparables even more, as they dominate in most industries they compete in and compete internationally, as emphasized in the previous chart (Note: Recent changes have allowed them to compete in Life Insurance, so their market share would be markedly higher than shown).

This concentration in the Big Five banks give regulators an amazing amount of control over the financial system, and lack of proper competition has prevented the Canadian Banks from needing to compete on price, so they will straight deny risky loans to high-risk borrowers, a gap filled by the quick growing but struggling Home Capital Group, and Equitable Group, for examples.

This has allowed CMHC, the Canadian Mortgage and Housing Corporation, which acts as an insurer of highly leveraged mortgages (much like Freddie Mae and Fanny Mac) to dictate the terms with which banks can lend to higher risk borrowers, with onerous restrictions if the client cannot put up a down payment of at least 20%. This low-risk underwriting by the banks, and high requirements from CMHC for risky lending, has built in a robustness that is lacked in the U.S. financial system.

These all compile to keep Canada's banking system one of the most robust around, and helps protect consumers from a possible correction in housing prices.

Accidental Commodity-Price Leveraged Economy

Canada is weirdly dependent on commodity prices. The stock market has been a laggard due to the very high concentration in these industries in our stock market, but when you look at major commodity prices compared to the return of the TSX, you see that it's still plugging along:

Source: Google.com/finance

  • iShares MSCI Canada ETF (NYSEARCA:EWC)
  • SPDR Gold Trust ETF (NYSEARCA:GLD)
  • iPath S&P Crude Oil Total Return Index ETN (NYSEARCA:OIL)
  • iShares Silver Trust ETF (NYSEARCA:SLV)
  • The United States Natural Gas ETF, LP (NYSEARCA:UNG)
  • PowerShares DB Base Metals ETF (NYSE:DBB)

As we can see, the last five years have been pretty brutal for commodity prices, most even losing the strong gains into 2012. Canada has plunged too, despite a full 71.36% of its stock market being largely untied to the commodity crisis and the economy not as sensitive to housing market collapse as many other countries. Primary industries are about 6.2% of Canada's GDP and 4% of employment. 58% of Canada's exports were primary related, responsible for about 22% of Canada's GDP.

So a country with almost 78% of its economy unencumbered by these terrible commodity prices, why in the world would it trade largely in line? It's because Canada's companies are significantly undervalued, when accounting for the reduced earnings power of the primary and commodity based companies. International selling of Canadian products has punished all companies to some extent, and as the non-commodity companies have succeeded, that success has been impeded not by market conditions, but by over-selling by those linking them too closely.

Let's look at the same chart with a fund that has reduced exposure to the sector:

I have added the SPDR S&P 500 Trust ETF (SPY) for effect, but needed to change the time scales as TSE:XMV has only existed since mid-2012.

The targeted ETF has a minimum volatility, as it was the least exposed I could find, with about 80% of its assets untied to materials or energy. It is still trailing the S&P 500, despite a stronger yield and P/E ratio of 17.00. It's also important to note that in U.S. dollars the iShares MSCI Canada Minimum Volatility Index ETF (TSE: XMV) has not performed as well as showcased compared to the other companies as it is in Canadian dollars, which has been hit very hard lately and the rest are in U.S. dollars. Adjusted for currency exposure, XMV would be very near EWC, which is not currency-hedged, meaning they trade essentially in line, despite 11% less commodity and energy exposure.

With these factors in mind, an improvement in the commodity space would not just help Canada; it would arguably move everything higher, including companies that have no tie to that industry. Canada has made itself a leveraged play on resources since its weighting to resources is higher than most economies. But that high weighting doesn't mean Canada is exclusively tied to the primary resource markets. In fact, so much is not tied, its beginning to allow purchase at a significant discount without needing to be concerned with resource prices. They will eventually recover, and in the meantime you can accumulate great assets that trade at a discount due to resource exposure.

Conclusion

With all that in mind we come to a place where Canada, with resource exposure greater than most countries, suffers a very weak currency and poor stock performance. They are also in a rate-cut war with other global commodity-linked currencies. The housing market is about as overheated as the rest of the world, and our citizens are less leveraged than other developed economies. This all turns into an interesting case of why exposure to Canada is interesting for all investors, including U.S. based ones.

For me, I recommend U.S. based investors bearish on commodities and energy participate in the Canadian market by targeting very specific sub-sectors, those that have been punished with the headline TSX where there is little basis for it. I was unable to find U.S.-listed participation that did not include the relatively heavy materials and energy weightings, but there are opportunities in individual stocks like those I and other Canadian author highlight, and in certain ETFs if your brokerage allows you to purchase directly on the Canadian exchanges.

For those like me, I do not mind playing the total market as I believe that Canadian resource companies are some of the best around, with ample Canadian financial firms interested in granting loans in the meantime, as it has one of the best developed materials and energy investment and financing in the world. There is a reason companies list in Canada, and there is tremendous upside should the thesis play out.

Even more things for investors to consider, in the very curious case of Canada.

Source

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long the Canadian market through individual companies whom I believe will individually outperform. I currently have no funds invested in broad ETFs in Canada, though my default position in Canada if I have no stronger ideas in the market itself is either the TSE: HXT or the TSE: XMV.