Wednesday I wrote an Intro to the City of Toronto Housing Market and yesterday I wrote the Negatives I currently see in the market. If you haven't, you can read those two blog postings here: highrockcapital.ca/pauls-blog.html
Today is Part 3, the Positives. After reading yesterday's blog, reading front page newspapers, reading most major bank economist's reports and some perma-bear real estate bloggers, you might be surprised there are any positives to find at all. Actually, there are quite a few. I won't give away Part 4 for Tuesday (My Conclusions) but suffice to say that the Negatives are more short term in nature (now to 12 months) and the Positives are longer term in nature (12 months till...forever).
This blog will be a lot longer than yesterday's and I will use more charts and less words (at least I intend to).
The blog will focus on supply of housing stock (massively affected by public policy) and demand for housing stock (massively affected by public policy). Given both supply and demand are massively affected by public policy, we need to take a trip back over 10 years ago to figure out what public policy measures came into play and changed everything for the City of Toronto (and surrounding areas) housing market.
First we need to look at how Canada and Toronto are growing their population. Canada is unique amongst the OECD and G8 countries. Canada has the second largest land mass but yet is the most geographically concentrated populations at 82%.
About 80% of the population live in a skinny band within 160kms from the US border. And 17% of the population lives in the City of Toronto. Canada has the fastest growing population in the G8.
The Greenbelt and Places to Grow Acts 2005
The Greenbelt Act was put into place to protect about 1.8mm acres of environmentally sensitive and agricultural land in the Golden Horseshoe from urban development and sprawl. And the Places to Grow Act effectively limited new development with a complicated formula, I couldn't even begin to explain properly. The effect of these two Acts was to "densify" the City and it was entirely intentional. Sure, the Province cares about protecting the lands in the Greenbelt, but there is an ulterior motive to both Acts and they are, at least partially, to blame for what some people think is too rapid a rise in detached and semi-detached home values over the past decade.
Back in the 1970's, when oil was cheap, urban sprawl was popular because the cost of transportation was so inexpensive. Think about those communities to the east and west of the city that developed rapidly. I grew up in Burlington in a pretty good sized 4 bedroom house, on a big lot, with a two car garage etc. Plenty of space for a family of five. Now as oil and transportation costs rose through the 90's and 00's, and the fact that the Province didn't invest in toll roads since the 70's to be able to invest in proper transportation infrastructure, they found themselves in a pickle. Due to fiscal constraints (budget deficits and debt) they could no longer afford to build proper infrastructure to support the urban sprawl. So they passed the Greenbelt and Places to Grow Acts and forced builders and the growing population to move into the City and utilize the existing infrastructure in the City (as bad as we may think it is at times, it still works). So the Province and the City planned migration and densification a decade ago out of necessity. They quite simply could not afford any urban sprawl.
A more cynical view, but I think a complete reality is, densification is way better tax revenue for the City. Think about this -- a developer can put 50 fully-detached homes on a plot of land north of the core. The builder is responsible for putting in roads, sewers, streetlights etc but after the last house is sold, he is gonzo. The City is then left with the cost of maintaining all of that infrastructure, along with garbage pick-up, police, fire, snow removal etc and it all gets paid by 50 property tax payers. OR, the City forces builders to build a 50 story condo tower on a corner in the downtown core (a quarter of a block, if that), and can move in 400 taxpayers on that tiny footprint. Those new condo dwellers are utilizing existing infrastructure. It's all about tax revenue and the utilization of existing infrastructure (because they can't afford to build new infrastructure).
And an anecdotal view I just heard...apparently when Premier Wynn was consulting with Bay St economists behind closed doors, she responded to a question about no new supply of detached housing ever coming on in the City with "I don't give a #$%^& if the is never another single family house built in Toronto again". There you have it.
The Greenbelt map below shows these lightly shaded areas and lines showing the "buildable areas" in the GTA. I have been told that these areas of buildable land are held by about five long term investors (Vic de Zen, Mattamy Homes etc) and they are not sellers as they are well-aware of the public policy dynamic and it's long term effects on house prices. Note - there is obviously no buildable land in the City itself. The land is out Brampton way - hardly the City of Toronto.
Most large cities in North America have some sort of Greenbelt to protect from urban sprawl. Greater Vancouver Area shown here. The City of Vancouver near the top-left...pretty tiny space.
There are land constraints in most cities and those with the most, will see the highest population growth, densification and home price appreciation. Land constraints come in two forms: 1) physical (bodies of water, mountains) as we can see in Toronto, Vancouver and New York (if we showed the map) and 2) public policy (The Greenbelt and Places to Grow Acts).
Condos "Going Up"
With land constraints being enforced by public policy and the obvious physical constraints, the City can only grow upwards. That means condos. As mentioned, there is no land to build in the City, only part of a block for condo developments. Note how Condo New Starts in the City completely dwarf Single Family in the lower chart:
How many times have you heard people over the last 30 years say that Condos are in a bubble? It ain't a bubble. There is demand from aging baby boomers and from millennials...the two fastest growing demographics for the next 30 years. Ryerson Professor Frank Clayton wrote a paper August 2016 titled "Will GTA Homebuyers Really Give Up Ground-Related Homes For Apartments?" In his paper, he states that 82% would favour ground-related single detached homes vs apartments. I don't think it matters what they would prefer...they don't have a choice...there is a finite supply of ground-related homes in the City and no supply coming. Think about other major international cities in the world...New York, Paris, London, Boston, Rome etc. How many Detached homes exist in any of those cities? Zero. Multi-level living is the norm. Raising a family in any of those cities means doing so in a 3 bedroom flat, walking or taking the elevator down to the the park across the street to kick a soccer ball or ride a bike with your kids. It is a fact of life in the fastest growing country in the G8 and the fastest growing city.
So if there are more Condos going up and no new Detached homes being built, what do you think has happened and, will continue to happen, to the price spread between Detached and Condos in the City? Widen it shall. See the table below and see what has happened over the last 20 years in Toronto. The Detached-Condo spread has gone from $102,000 in May 1997 to $939,040 May 2017. When land constraints exist with fast growing population, along with public policy to limit single family construction and force densification, the spread has to widen. Can it widen more? Absolutely. Look at the average selling price of a Manhattan Brownstone vs a Coop. The data only went back 6 years but look at the gap in blue...from $4.6mm to $7.8mm differential. The public policy puts land, especially Detached Homes, at a serious premium. And keep in mind when looking at home price appreciation - it is actually nowhere near as substantial as reported. Think about the small and large renos that most homeowners do that naturally add value to the home price. It is not all capital gains.
Toronto a World-Class City?
What we do know, is that Canada is the fastest growing country by population in the G8 and Toronto is the fastest growing city in Canada, and likely the fastest growing city in the G8/Developed World. Census Canada data comes out every 5 years and is not stellar but the City (proper) grew from 2011 to 2016 by 116,511 people to 2,731,571. That is 23,302 per year. Census data estimates that household formation occurs with 2.4 people per household. That creates household formation of about 9,700 per year looking for a place to live. And that is just the City. In the GTA, the numbers according to Census data are growth in population by over 100,000 per year and that is increasing due to increased immigration. I think it is fair to say Toronto (and arguably Vancouver) are International, World-Class Cities. If so, we shouldn't compare property values in Toronto to homes in Halifax or Edmonton or Calgary. We should compare them to other International, fast-growing cities.
What does U$1mm buy you around the world?
The table above shows how much square footage you can buy for U$1mm around the world. Monaco is the most expensive at 183 sq ft while Beijing is the least expensive of those shown at 624 sq ft. Vancouver at 730 sq ft and Toronto at 820 sq ft seem cheap internationally.and don't even make it near the Top 10 on this expensive/value scale.
And shown another way, is Home Price to Income levels around the globe
Starting with the cheapest on the far left we see Montreal, then Melbourne and then Toronto. Check out those international cities...Stockholm, Paris, Rio...really? Yes sir. What has happened is that densification has occurred in all of these international cities long ago and it is just starting to happen in Canada over the past decade. One could argue that Toronto (and Vancouver last year and now it is Montreal's turn) are simply playing catch-up, especially with the big move we had over the past year. Anyone want to take bets on when the Province of Quebec and City of Montreal step in with their own measures?
Now both of those last two charts compare downtown apartments. If we look at the City of Toronto and compare it to other International Cities, it gets even better when you compare data on single family homes. The fact is, most of these other large international cities do not have Detached Homes, period. The best you can get in London or Manhattan is a Brownstone (that is 1-3 families per Brownstone). Stating the obvious here but a Brownstone style home has no driveway, front yard, backyard, etc and you can probably hear your neighbours on each side and the constant hum of traffic day and night. Big city living, I suppose. If we take Manhattan or London, sure you would be living in the City and your commute would be about 20-30mins by subway. But in Toronto, you can live even closer to the downtown core than in Manhattan or London and your commute would be the same or less. But, you get a fully-detached house with two-car parking, front and back yards, quiet neighbourhood etc. Ask anyone here on an expat package what they think of the standard of living in a large Toronto house, on a large lot, in a leafy neighbourhood and commuting a whopping 6kms (11 minutes) to the office downtown. You always get the same answer - "unreal and cheap". Land is at a premium.
Now I am not for a second comparing Toronto to Manhattan or London real estate on an outright basis, yet, but you can see the trend developing and it makes more sense to compare Toronto to these two cities (and some other international ones) than Edmonton. Just playing catch-up on an international basis perhaps?
Debt Service Ratio
I showed yesterday that a clear and distinct negative exists in the fact that Canadian consumers are rather levered right now at all-time highs around 160-170% of Personal Disposable Income. That is not a great stat, to be clear. However, the cost of servicing that debt is still in-line and the cost of paying interest-only, like on a HELOC (Home Equity Line of Credit) is the cheapest it has ever been.
The obvious problem with relying on this level of debt service remaining cheap forever hit home the past week when Bank of Canada (and other central bank) officials all talked in unison about raising rates. No doubt a clear and present danger. The only positive one can pull from that would be that, like the Fed in the USA, they make a policy error by raising rates too quickly, the economy (and housing in Canada) get hit hard and ...rates fall and the central bankers follow with interest rate cuts. And that is really reaching for a positive.
And without doubt, lower rates/mortgages have driven house prices to some degree too; not unlike any other asset (bonds, stocks, commodities). Homes, the same as any other asset class, are all about "carry". Carry being...what can you borrow money at to invest in an asset and what sort of return can you expect that asset to produce. In the chart below - GVA home price at the top, then GTA, then Canada and Calgary on top of eachother. 5yr Mortgage rate on the bottom. The correlation probably makes sense but 2005 when prices started to accelerate, was also when the Greenbelt and Places to Grow Acts came into being.
More Public Policy
Last April, the Province of Ontario passed a 15% foreign buyer's tax on the Greater Golden Horseshoe area homes. I have two main problems with this:
So let's have a look at price appreciation of some asset classes.
And keep in mind that the Detached home owner probably did a renovation or two (or maybe a complete gut job for $1mm) to get that price appreciation. I didn't make assumptions and calculate it but if you assume $500,000 of reno's over 20 year for a detached Toronto house, you wouldn't be far off and the CAGR would drop to 7.7%. Does that seem excessive to you? Not to mention all of the associated costs with home ownership - property taxes, land transfer tax, real estate commissions, etc. Not sure I get it.
Also note that when comparing a primary residence investment to a single stock or an entire investment portfolio, there are significant tax differences - the former is exempt from capital gains tax while the latter are subject to capital gains tax.
Shouldn't the Province do something about Royal Bank stock? Maybe step in and put a ceiling in place on Canadian Bank stocks so they can't rise any further and more people could then afford to buy some?
Back to Some TREB Data
Not a lot of positives in the TREB data, as shown yesterday and mentioned above, but a couple of ratios to look at anyway:
Looking at City of Toronto Detached Home Prices to Active Listings and Sales show that Price has already come off pretty hard in the month of May vs Active Listings and Sales. Again, June's TREB data comes out next week so we shall see when it arrives.
What Happened in Vancouver?
Given Vancouver enacted a similar public policy on foreign buyer's tax a year ago, and Vancouver and Toronto share similar land constraint issues (both public policy Greenbelts and physical constraints), it probably makes sense to look at what has happened to house prices over the past year in the Greater Vancouver Area (GVA) to try to forecast what might happen in Toronto.
Here is what it shows:
The one catch here, on the negative side for Toronto, is that GVA Listings were coming off since 2012's peak. Toronto would need to see a similar decline in Active Listings before it could possibly see Price increases back to the peak April 2017. Could that take a year? Sure could.
Ok that is it for the Positives on the Toronto housing market. Sorry, wrote way more than I thought I would (and I had even more research I stripped out).
Have a great Canada Day Weekend and tune in Tuesday for my conclusions on this topic.
NB. This data was collected from CMHC, StatsCan, NBF, CIBC, Province of Ontario, TREB, Ryerson University.
Bad news first (for homeowners anyway).
Residential real estate is an asset class, like most others, save for two glaring facts: 1) it represents a crazy amount of leverage that most people would never think about using in a well-diversified and liquid portfolio and 2) it is a very emotional asset class (you likely love the home you live and raised your family in) more than a particular investment in your investment portfolio. Nonetheless, it is an asset class and when we begin a new relationship with a private client (and every six months after that)) the first thing we do is a Wealth Forecast where we get a sense for what your assets and liabilities are, monthly expenses, goals for the future etc. The output from this determines how much risk we need to take for you to achieve the required return to meet those goals. For sure, your house (and mortgage) are included in this Wealth Forecast as part of your assets and liabilities.
Anyway, on with the topic at hand...the bad news on what is happening, and might happen in the City of Toronto housing market. This will largely be a chart and explanation format.
First of all, on a Canada-wide basis, housing now represents about 20% of our total GDP (Gross Domestic Product). That is up from 17% in 2000. Not a huge increase but, to be sure, it matters to our economy.
At 20% of our economy, one could argue, "so goes housing, so goes the economy".
Keeping with the Canada-wide theme, another negative for the economy/housing market is the fact that the Canadian consumer is very levered. You have probably read about this on the front page of the papers. Remember how Canada was largely spared from the credit crisis in 2007 thru 2009? The Canadian consumer was under-levered at the start of the crisis in 2007 and, as interest rates fell, they began to lever up and spend our way out of what would have been a deeper recession in Canada, while our cousins to the south had to delever..Tables appear to be turned today. Although the media reports our Debt/PDI at 170%, on a apples-to-apples comparison to the US metric, we are at 157% (removing business loans from consumers). Nonetheless, getting up there and at all-time highs.
So far, we have a picture of housing being an important and substantial part of the Canadian economy and a consumer who is sitting with all-time high amounts of leverage.
Given the Bank of Canada (BoC) has suddenly changed their tune on interest rates (read Scott's blog from this morning: highrockcapital.ca/scotts-blog/central-banks-and-boc-singing-a-different-tune-on-rates), there could be very serious ramifications, on a mcaro basis, for housing. The fact pattern would go like this: BoC hikes rates, consumers get nervous about the leverage they are carrying and their ability to finance it if rates go up a lot, they pull in their spending, including home renovations (a big part of the home price increase that isn't captured in the data on home price appreciation), less renos and spending at Home Hardware means less of a multiplier effect in the economy..et voila...the BoC would then have a recession on their hands.
Part of what the BoC says/does on rates obviously affects the C$ and that affects (or used to to a larger degree) how foreigners look at our real estate as an investment. The C$ matters. Last summer spot Canada was at 1.2765 and it weakened up to 1.3800, representing over an 8% decline against the US$ making Canadian housing look that much cheaper. However, over the past two months, the C$ has increased in value from 1.3800 to 1.3000 showing an almost 6% strengthening, thereby making Canadian housing look more expensive.
And I will have more to say tomorrow on asset classes that the various levels of government insist on meddling in but, for now, we are all aware of the measures the Cities of Vancouver and Toronto have taken to affect the residential real estate asset class and those actions are clearly a negative.
The combination of the C$ strengthening that much in two months, BC and Ont effectively pushing foreign buyers out of investing in our real estate, and the BoC on the verge of hiking short term rates (who cares that inflation is plummeting?), one can only draw negative implications for Toronto housing.
City of Toronto
Now onto some Toronto Real Estate Board (TREB) data I have compiled. I generally used monthly data (it comes out every two weeks for members, which we are not one of) and only went back to July 2011 for time's sake. I created an excel file on various groups of stats and then created some charts to represent it better. Keep in mind, June data comes out publicly the first week of July (we hear, and intuitively know, it won't be great)
The first chart shows some fairly daunting stats around Active Listings, Home Sales and Sales Price all for City of Toronto Detached. I have some data for Semis and Condo Apartments which will be layered in at other times but, for now, let's just look at Detached homes as they were the hardest hit the past month. An explanation on each chart to follow.
First thing to note is that there is obviously a seasonality factor,as you can imagine. Most folks want to buy/sell in April/May/June so they can close in August, get moved in and settled before the school year and the last part of the work year begins.
As you can see, Active Listings were dropping/trending lower the last 5 years. The Average Monthly Active Listing since July 2011 was 1,580, to give you an idea. One of the reasons the market was going bananas in the Spring is because there was a complete dearth of Active (and New) Listings. For example, Dec had 488, Jan 543, Feb 656, Mar 987...all way below the 6 year average. And Semi-Detached Active Listings...77, 102, 123, 173 respectively. No wonder prices took off. But April saw 1,605 and May 2,242 on Detached Active Listings...we have to go back to Sept 2013 to see 2,235 Active Listings on Detached homes.
Why did Active Listings rise up so much in April and May? Quite simply, Sales (demand) dropped as buyers refused to participate in these bidding wars and New Listings (supply) came on to try to cash out. Supply increased while demand faded.
Detached Home Sales
As you can see from the middle chart above, Detached Home Sales are lower but not by a ton at 1,146 for May vs 1,268 for Apr and vs the monthly average since July 2011 at 981. The bigger negative here is that the month of May, as mentioned, is usually a bigger, seasonally strong month for Sales at closer to 1,500 than the 1,146 we just saw for May 2017. That ain't good.
Detached Sales Price
As you can see from the third chart above, Detached Home Sales Price trailed off a bit in May. It ended May at $1,503,868 representing a -5% drop month-over-month (mom) but still +17% year-over year (yoy). So looking back, we can see other months where the mom detached home price was down a similar amount...Dec 2016 at -4%, July 2016 at -5%, Nov 2015 at -5%, July 2015 at -5% and June 2015 at -6% and July 2013 at -8%. I suppose the optimist would say, "one month does not a trend make" as there are other months where the Detached Sales Price has dropped sequentially by as much or more over the past 6 years, however, May is meant to be a big selling month from a seasonal point of view and prices should follow up, not down. Note the other comparable mom decreases in prices were seasonally low months like Dec, June and July. Not a good sign of things to come, I am afraid.
Next, we are going to look at a ratio - Detached Sales to Active Listings.
Yikes! The only way to read this chart is that Active Listings have risen way faster than Sales are taking place which has moved the ratio all the way from 123% in Mar 2017 to 51% in May with a 6 year average being 66%.
As previously mentioned, buyers clearly pulled in their horns and decided enough was enough and sellers, who were on the sidelines last winter/spring, decided to all list quickly. Remember, April and May are supposed to be strong transactional months. We have seen this ratio come off in the past 6 years but it hasn't had a month of May where it has been below 60% (May 2013). I am not supposed to talk about positives for the market here but, being a contrarian, I can't resist...the only possible positive here is that the ratio of Sales to Active Detached Listings came off so fast and hard that it might settle in.
A word about New and Active Listings - I have been warned by some senior real estate agents (who I respect) that Listing data can be manipulated as listings come on one day and off the next and that may happen at the beginning or end of a month so it gets or doesn't get captured in TREB's data. Regardless, the trend seems apparent to me.
A final word on Listings, and just an anecdotal word. I receive a daily (midnight) email on specific houses I care about on certain search criteria (location, price, size etc). I can say that in April and May it took me a lot longer to read than in the winter. Listings were coming in like crazy. One problem...they were all crappy houses and crappy locations that folks were listing, all of a sudden, to ring the bell at the top of the market. They were never going to sell at those prices. June's numbers will tell us if those listings were pulled from the market making the ratio of Sales to Active Listings look better.
And the final chart on the negative side is the Detached Home Months Supply. This ratio is derived from Active Listings/Sales. Here it is again since July 2011:
Sudden spike as in some previous charts. We ended May 2017 at 2.0 months supply. The monthly average since July 2011 is 1.7 months. Mar and Apr this year were at 0.8 months supply. We have to go back to Aug 2015 thru Jan 2016 when it was between 1.7 and 1.9 months of supply to get close to May's 2.0. And Jan 2015 was north of 2.0 at 2.3. 2013 winter, spring and summer were all between 1.7 and 2.9 and the worst month was Sep 2012 at 3.1 months supply.
Some agents say "we don't have a problem with the months supply ratio until we hit 4.0 months". Respectfully, at least in the short run (6 months), I would disagree. Although we have seen spikes in the ratio before, the spikes are not typically in the prime transactional months of Apr and May, where the ratio seems to be in the range of 1.1 to 1.8 months supply.
That's it for the Negative side. Not exactly a pretty picture from the macro view Canada-wide to the various TREB metrics I have shown.
I won't even conclude my thoughts on the Negative side. Tomorrow will be the Positive side and then Tuesday will be the Conclusion on the entire market.
Keep in mind that there are other categories of homes such as Semi-Detached and Condo Apartments (obviously the largest). I will touch on these tomorrow. I have just used Detached as a benchmark for illustration purposes.
The City of Toronto (Vancouver house prices were last year's story so, further away geographically, as well as in time) housing market seems to be front and centre right now.
Without doubt, the market has come off over the past month alone, and that has led just about every Economist, journalist, former journalists, investment advisers, etc to hop on board and give their two cents worth. Some opine on the topic because it draws attention and draws readers/advertisers and some because of ulterior motive.
Why not two cents from a Portfolio Manager?
I have spent a bit of time going through City of Toronto housing statistics with some colleagues (far brighter than I). A few people (my wife included) asked me why I was doing research on the housing market? Answer - because housing (although most Torontonians think Toronto is the centre of the country, I am referring to Canadian housing in aggregate with this stat) is about 20% of the Canadian economy right now and could have ramifications for the economy, interest rates, various industry sectors and companies we invest directly in. Think of it as blending some Top-down macro research with some Bottom-up fundamental research.
Full-disclosure, my wife and I do own a house in the City of Toronto. It is the third house we have owned...the first being a semi-detached I bought at the bottom of the market in 1991 in the Beaches. We stayed there through the birth of our first son and then, when the second son was born, we sold and bought (actually, it was one day after he was born that we went directly from the hospital to sign the papers on the new house!) a new house near Yonge and Davisville. Two-and-a-half years flew by and guess what? We had a third son and about two weeks before he was born, we sold and bought another new house. And there we reside, 17yrs and three boys later. We may sell and buy again but it is highly unlikely we will be doing so because we are having a fourth son.
Anyway, in this four part series, I thought I would start with an Intro (today's blog) and then write Part 2 on the Negatives for the City of Toronto housing market (bad news first), Part 3 on the Positives (yes, contrary to what folks who are permanently bearish might suggest, there are some positives) and finally, Part 4 on my conclusions, which, like any investment, I will make particular to the investor...everyone has different goals and objectives.
With regards to data collection and presentation, I would add that it is wicked hard to get some of this data (like household formation) in any sort of accurate way. I asked a TD Bank Economist I know about getting the most accurate data possible and have also utilized a DBRS report from last fall's annual Credit Sweeps Conference written by Jamie Feehely (this guy puts every other analyst/researcher/strategist to shame on both the content and presentation of his materials...hilarious!). So data collection comes from TREB (Toronto Real Estate Board), StatsCan, CMHC, DBRS and National Bank. I do not use Teranet for Home Prices because their pricing methodology is an estimate of pairings, not actual transaction prices, like TREB.
I will try to keep the blogs brief and use as many charts as possible but really want to present data, not just "opinions". In some cases, I will present just numbers but will try to do so to make it readable.
So, barring a complete market meltdown, I will start with Part 2 (the Negative side) tomorrow.
Earlier this month, I wrote a blog entitled The Fed, The Economy, Interest Rates and Stocks, which you can re-read here: highrockcapital.ca/pauls-blog/the-fed-the-economy-interest-rates-and-stocks. Basically, I showed the Citi Economic Surprise Index vs US interest rates and stocks and something in there just doesn't make sense.
Some of you may have heard the terms for Economic data being bifurcated into "soft" and "hard". Soft being more Surveys and Indices and Hard being more empirical in nature (I like numbers...they remove emotion and don't lie, so guess which set of data I put more credence into?).
Today, I thought I would show Citi's Index of Soft and Hard US Economic data. Here it is
Yellow line - Soft Economic data
White line - Hard Economic data
What is interesting about the soft data is that, it represents emotion, feelings about the future, perceptions, etc so when it trails off, the result is that consumers and businesses (those surveyed) do not feel as positive about the future. And if neither of these groups do not feel as confident about the future, they arguably spend less. And if they spend less, the economy is not as likely to grow compared to if they were more positive. So if consumers and businesses are less confident about the future and spend less, then the government has to step in with yet more budget deficit spending to spur economic growth. The result of government (deficit) spending is - more structural debt. Do we need more government debt? I am pretty sure we have enough in every country and at all levels of government.
Is the US economy really that strong? Should the Fed really be raising rates?
I leave you to answer those questions but at High Rock we already have and are managing our portfolio risk accordingly.
Last week, the Department of Finance (DoF) and the Office of the Superintendent of Financial Institutions (OFSI) released more preliminary information on the rules for how an insolvent Canadian Bank would be re-capitalized. I have written about this before but thought I would touch on it again as it is very important. Although complex, I will try my best to keep it short and to the point (I should probably use point form so as not to be too long-winded).
These rules were brought upon the global banking industry after the credit crisis by the world's global banking regulator, the Bank for International Settlements (BIS). The rules are commonly called "the Bail-in regime" and their intent is to protect tax payers from re-capitalizing a failed bank and instead force the current security holders (various levels of Fixed Income securities and the Equity/Stock) to take the losses.
Here is how it is supposed to work in Canada (and most other places in the world, save for Italy apparently...more on that at the end): :
Upon a triggering event, the actual bail-in works like this:
In a nutshell, that is how bail-in is supposed to work. There is public consultation set for July 17, 2017 and it is expected that these new regulations will be implemented in the 1H18.
Why is this so important to us at High Rock?
For these reasons, High Rock has not (and likely will not, unless there is an arbitrage or enormous opportunity) owned any NVCC, Bail-in or Common Stock of a Canadian DSIB. And I can tell you that even within the Pref market, we do not just buy Pref shares ad hoc or buy an ETF on the Pref market. Our clients/mandates own very specific non-bank Preferred shares, and not just because we didn't want to own NVCC, but that is a discussion for another day. Remember, we focus on risk-adjusted returns at all times.
As for Italy, today was the second time in about three months where they ignored BIS rules/regulations on recapitalizing a DSIB. Although the equity of these two banks was wiped out, Italy dumped about 17 billion euros into these two banks so as to protect senior unsecured bond holders...goes against the new bail-in regime so, hey, who knows, maybe these rules are flexible. It's ok, Italy can afford it...their Debt/GDP ratio is only at 132%...
The US Federal Open Market Committee (the Fed) just concluded their two-day meeting and, as expected, raised the Fed Funds overnight bank lending rate by 0.25% (25bps or basis points) to set the upper band at 1.25%.
No real surprise in their move just now at 2pm. What is a surprise, is the Citigroup Economic Surprise Index. I wrote about this last week here (highrockcapital.ca/pauls-blog/what-happens-when-an-economist-is-wrong-on-their-predictions). The surprise is the fact that Wall St economists have been predicting a stronger set of economic numbers since Mar/17 than have actually been reported...hence the surprise has been to a lower Index and a weaker economy.
Yet the Fed is raising rates into this weakening economy. And usually when the economy weakens, inflation (and inflation expectations) weakens too. In fact, that is happening right now (just this morning, in fact, with a lower print on US CPI) with recent inflation metrics being reported sequentially weaker and weaker than economist's expectations.
And the bond market is certainly speaking it's mind with rates in the longer end of the curve moving lower (higher prices) which is foreshadowing the fact that the Fed is making a policy error by hiking too soon. And the yield curve (the spread between short bonds like 2yrs and long bonds like 30yrs) continues to flatten, further signalling a policy error.
And finally, stocks. New highs. Why not?
Weaker economy, higher short term cost of funds, lower inflation/growth = higher stocks. Make sense? You're not alone.
In chart format:
Also note how US 10yr bond yields are hitting new lows for the move and have retraced about 62% of the Trump move to higher yields on the back of growth and reduced regulation prospects.
It is becoming more likely that the Fed is hiking rates right into a recession.
As most of our clients know, we invest our collective money across the entire capital structure of companies. The capital structure of a company is comprised of all the securities they issue to make up their capital: bank debt (at the top), bonds, convertible bonds, preferred shares and finally stock/equity (at the very bottom). So if we like a company, we are going to invest in that part of that company's capital structure that we feel will provide the best risk-adjusted returns. Buying stocks is not the only way, and usually not the best way, to garner the best risk-adjusted returns.
Below I will show a good example of a Canadian oil producer (Baytex Energy) that has both stock and bonds (I will use just a C$ bond in this example) outstanding. Here you go, with an explanation to follow:
Ok, here is the explanation on this busy chart:
Things to notice from this chart:
It is #4 that has me thinking. Usually, like back in 2015 when oil was getting hammered, it was the underlying high yield bonds that traded lower in advance of the underlying stocks. Remember, bonds (both government and corporate) tend to lead all other markets, including stocks.
So what does it mean that the underlying high yield bonds of these oil producers, like BTE, are not selling off, either in advance or concurrently? Will they sell off after the fact and actually lag the underlying stocks? Or are the stocks now really, really cheap? And what about the price of oil...up, down, sideways?
I am still in thinking mode on this one so, I have no definitive answers for you on the above questions. I will, but not right now.
And here are the Total Returns for these securities from 12/30/2016 thru 06/08/2017 (YTD on a daily basis as per Bloomberg) so we can get a better picture:
Now the reason BTE stock, and any other oil producer, would be down as much, or more, than the actual price of oil is quite simply because they have leverage (debt) and that produces operating leverage which exacerbates the moves up and down vs the price of oil. In this case, to the tune of 3x more than the price of oil.
But BTE's underlying bond? Price hasn't really changed and, including the almost-six-months of coupon, it is actually +2.86%. Who says you can't make money in bonds?
So I will put my thinking cap back on and figure out if BTE stock is super cheap or these bonds are super expensive. As is always the case when investing in companies, especially in commodity-related companies, we need to get the call on the commodity right first. That is the key.
No catchy title on this one, although I could also have titled it "The US Economy, Part III" following on yesterday's blog (highrockcapital.ca/pauls-blog/what-happens-when-an-economist-is-wrong-on-their-predictions) and Tuesday's blog (highrockcapital.ca/pauls-blog/interest-rates-are-going-up).
Although not the largest category of US Bank Assets, Commercial and Industrial (C+I) Loans and Leases are the blood going through the veins of the entire US economy. These are loans and leases extended to commercial and industrial businesses across the US.
Here is the chart of US Commercial and Industrial Loans and Leases (white line) with the S&P 500 overlaid (yellow line).
Notice how the S+P tracks C+I Loans and Leases? The more the economy grows, the more large banks want to take the credit risk of C+I companies and extend Loans and Leases to them and...the higher the S+P goes on this economic growth. That is the circle.
What you can see in this chart is that since the Great Recession of 2009, C+I Loans and Leases have been growing rather steadily (blue dotted line) until June 2016. And the S+P followed C+I lending higher through that period of 2010-2016. Credit expansion = S+P moving higher.
However, what I have noticed lately is that C+I Loans and Leases have largely been moving sideways for the past year (blue solid line) and yet the S+P has ramped up further (solid green line).
Conclusion? To be honest, not sure. What I do know is that we need to watch this closely (not every day or even week but maybe every month) to see if large banks want to continue to grow/expand their C+I lending books or are they beginning the process of shrinking/contracting them. Are these banks more or less positive in the credit quality of these C+I companies they are lending to? The very fact that these banks have not been increasing their collective C+I loan books tells me that they are not quite as positive on the credit quality of these C+I companies, and maybe the economy in general.
And why is that so important? Quite simply, credit (loans, leases, mortgages, bonds, etc) is the lifeblood of the economy; it is the oil in the machine. Without credit, the economy does not grow. Never mind not growing, businesses do not even operate without credit (debt). The more it is available or extended to businesses, the more those businesses can expand and grow, which of course leads to the overall economy growing, which means businesses are producing better cash flows. And what are we buying when we buy a stock (or a bond)? Answer - future cash flow streams. More cash flows = higher stock prices.
Bottom line is - so goes credit expansion, so goes the economy, so goes cash flows and so goes the S+P. One should conclude that the opposite holds true when credit contracts. For now, C+I credit is just moving sideways, but as mentioned, this needs to be monitored closely.
Answer - Not much.
Although most Wall and Bay St (the Street) Economists (some happen to be friends of mine so I will be gentle) are called "Doctor", due to the fact they have a Phd, no one dies if they make an error or a bad call on some economic statistic.
Pretty much every day of the week, there are series (most are monthly series) that are released by the issuer (The Department of Labour for Employment reports, as an example) and the Economists all jam data into their models and come up with their best guess for each series of data in advance of it's release. Combining all these series of data, each Economist hopes to correctly predict the state of the economy, the consumer, corporate health and growth etc and be crowned by Institutional client voting (we get asked to vote on various Analysts and Strategists each year) as the most accurate of all. Job well-done.
So given that background, and on top of the blog I wrote yesterday (highrockcapital.ca/pauls-blog/interest-rates-are-going-up), I wanted to add one single chart to help describe what is happening in the US economy.
Citibank publishes an interesting Index called the Citi Economic Surprise Index. This Index simply measures the difference between the average estimate from Street economists on an economic series vs the actual numbers that came out on that same series. Citi then compiles all of the series of data to form this Index so that we can get a snapshot on how the actual economy is doing vs how the Street economists think, or thought, is was doing.
Without further explanation, here is the Citi Economic Surprise Index over just the past year:
Picture's worth a thousand words ain't it? Red line = Down = Weaker Real Data vs Economist Predictions = Weaker Economy = ?
What this tells us is that, over the past two months alone, the Economist's projections on the various series of economic data have been far too optimistic for reality. That is to say, the actual numbers in the economic series of data came in weaker than the Economists had estimated. Don't worry: no one died!
I should have titled this blog as Part II to yesterday's blog because, in that blog, I questioned whether the Fed is making a policy error by raising short term rates prematurely and creating a recession all by themselves. This Citi Economic Surprise Index dropping like a rock might be supportive of that view. US stocks at all-time highs, Fed hiking rates and the economy weakening - not a great combo, if you ask me.
Next time someone tells you the US economy is strong, growing and you have to be invested (with them, if they are after your money)...show them this chart.
Really? We hear it all the time..."Interest rates (government bonds) have nowhere to go but up". I remember hearing it from less-informed colleagues in 2009 and 2010, Investment Advisors since 2011. Not many have been bullish on yields going lower.
What is really interesting the past 6-9 months is that 10yr US treasury yields have largely peaked out at 2.60% in Dec/16, then again in Mar/17 and now look to be breaking down to post-election lows at 2.14%.
And the most interesting part is...the Federal Reserve Board (the US central bank) has raised rates two times (.25% or 25 basis points) since the election (Dec and Mar) and still look set to raise them again in June by 25bps and maybe even Sept or Dec.
And if it isn't enough that long bonds are moving to lower yields with the Fed raising short rates, the Fed is also talking about shrinking their balance sheet (filled with government bonds and government insured mortgages) later this year from the $4.5 trillion it currently stands at today compared to the $800 billion it was at pre-crisis in 2008. Conventional thought would have it that if the Fed stops buying government bonds, clearly bond yields would rise...not so fast.
Here is the chart of US 10yr Treasury bonds in yellow and the upper band of the Fed Funds rate (the rate the Fed lends overnight money to the major banks at) in white and the horizontal red line is the day after the election when US 10yr Treasury bonds were at about 1.90% vs today at 2.15%:
So what gives? Why are 10yr bond yields moving decisively lower (remember, bond yields and prices move in the opposite direction so lower yields mean bond prices are moving higher) if "interest rates" are moving higher and the Fed may start to shrink it's balance sheet?
First thing is to determine which "interest rates" are moving higher. Clearly, right now, it is only very short term interest rates, like the overnight Fed Funds rate, that are moving higher. The "yield curve" is a very complicated beast that extends out to 30yr yields, which are called the "long end" or the "back end" of the yield curve. As we can see from the chart above, the 10yr yield has been "rallying" or moving lower certainly since March. Why?
The answer to that question is two fold, but the answers merge with each other:
And what conclusion do we make from long bond yields dropping in the face of the Fed raising the Fed Funds o/n rate?
Given the massive short covering that has gone on the past few months, we will have to see if the fundamentals play out (no inflation and a policy error being made by the Fed) or it the move to lower yields was all just a short covering rally. I think the former combination, to be honest.
Either way, High Rock accounts will maintain a position in longer bonds as a natural hedge to the other risk assets (stocks) in our portfolio.