Is Canada Ready For Poloz?

by: Turtle Tree Capital Ltd.


The market has priced in the rate hike according to CAD/USD.

Too low for too long?

Canada's low-rate environment has let consumers indulge above their means.

On July 12, The Bank of Canada (BOC) will announce the decision regarding Canada's interest rates. The low-rate environment in Canada was utilized to offset the decreasing price of oil, helping decrease the value of the CAD and encouraging foreign investment. Although, the intentions of the low rates go back to basic economic theory and when a country decreases interest rates, the value of the home currency decreases relative to other countries making Canadian goods and "equities" cheaper for foreigners. The BOC had used these measures according to a macroeconomic outlook, but this was taken advantage of by consumers and this is where the problem exists, creating hesitation for Central Banker Stephen Poloz and he is, no fool.

Consumers took advantage of Canada's low-rate environment, and let human nature take its course. As low rates allow cheap borrowing, banks receive an overnight rate of 0.50% inducing cheap borrowing on a commercial and retail level. The problem lies when most of this debt is used by consumers purchasing unproductive goods and services rather than businesses using the cheap money to invest into the economy to create jobs and increase Canada's productivity base. Consumers have used their capacity to borrow to purchase big ticket items. The recent record in auto sales (2016-1.95 million) (Canadian and U.S. auto sales) and the unsustainable boom in housing prices are a few signs of consumers making large unsustainable purchases, making consumer indebtedness now Poloz's biggest fear. You could go on to analyze the aspects of the housing and car markets to extract exact numbers or data, but this should be pretty intuitive to any financially minded individual.

This prolonged low-rate environment has created problems as consumers overextended themselves with assets that could potentially render negative equity, as debt based asset purchases can be more volatile as they are essentially leveraged. The increase of 25 basis points to the interest rate may not have an apparent impact but borrowing becomes more expensive for businesses and consumers, and as debt levels on a micro level have increased any sudden shock to aggregate demand on a macro level would shock the economy. Canada's interest rates are similar to playing with fire, as keeping low rates induces more consumption and increased debt levels, raising them makes debt more unsustainable as this increases the cost of borrowing. Here lies a predicament for the BOC's governor, and by his comments of Canada reaching excesses capacity, he is aware of the potential risks associated with hiking interest rates (Poloz's Speech). We could analyze various data regarding aspects of debt to income levels, average mortgage price to income, personal consumption and the impact of the wealth effect attributed to increased asset valuations, but the intention is to explain regardless of the interest rate decision, Canada's economy is in turmoil.

The increasing of interest rates should send mixed signals as they will bring about risks to the marketplace for investors who are interested in Canadian equities. The depreciation of the USD is making Canadian equities not as cheap as prior to the lower rates and foreign investors outside of Canada should be aware of the potential risks that will arise with increasing rates. As the Toronto Stock Exchange (TSX) hovers around the 15,000 level, which is up above 20% from the beginning of 2016, it has grown at a faster pace than Canada's GDP (StatsCan GDP Data). The growth could be impacted negatively when increasing rates are applied in Canada as higher rates could affect aggregate demand and fluctuate the TSX due to decreased earnings. Investors should take precautionary measures and be patient when trying to analyze the outlook for the Canadian market. The main sectors investors should be wary about are ones pertaining to consumer discretionary and sectors related to purchases being financed, such as housing and automotive manufacturers. Consumer Staple stocks and other less leveraged energy and mining stocks would be an investor's best bet for sector performance because other sectors have flourished from cheap borrowing through lower rates.

Chart ^TSX data by YCharts

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.